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QUESTION 1 [ 2 5 MARKS ] Company BBB is one of Country B ' s largest house - builders. In 2 0 1 5
QUESTION MARKS Company BBB is one of Country Bs largest housebuilders. In BBB sold over houses, ranging from apartment buildings to individual family houses. Customer satisfaction is considered key to the future success of the business and the company invests considerable resources in planning and delivering new homes to match customer demand. Customer demand depends heavily on property prices and on both the availability and affordability of mortgage finance. Upfront costs for BBB are considerable. Substantial capital investment is needed between purchasing the land for development and receiving payment for the houses. BBB therefore requires considerable borrowings and equity funding to support its operations. Over the last ten years, house prices have risen steadily and the housebuilding industry has generally performed well. This has enabled BBB to reduce its dependence on debt finance. There has, however, been some discussion amongst Board members regarding the capital structure of the company. Indeed, management consultants employed to review the company's financial management have recently recommended that BBB increase its gearing to a more efficient level. This would decrease the weighted average cost of capital WACC and hence increase company value. The consultants have undertaken a full review of historical financial data for both B&B and the wider housebuilding industry and have estimated that the theoretical gearing level debt to debt plus equity at which WACC is minimised is around for BBB There has been some extensive debate by the Board concerning the consultants' advice. The Finance Director, in particular, is very concerned about increasing gearing at all in the increasingly uncertain economic climate where interest rates are forecast to rise and banks are reluctant to provide companies with new funding. Financial data for B&B BBB has million ordinary $ shares in issue where $ is the currency in Country B The shares are currently trading at $ per share. The cost of equity is estimated to be BBB also has the following debt finance: $ million floating rate bank loan maturing in years' time with annual interest set at month interbank rates plus The month interbank rate is currently per annum. $ million of bonds are currently trading at $ and a yield of BBB pays corporate income tax at a rate of on taxable profits. Required: ai Explain the relationship between WACC and entity value. marks ii Calculate BBBs current: Gearing based on market values and measured as debtdebtequity marks WACC. marks iii Calculate, using Modigliani and Miller's MMs theory with tax, the theoretical reduction in BBBs WACC if gearing were to be increased to marks b Evaluate the Finance Director's stated opinion that BBBs gearing should not be increased in the current economic climate. Your answer should take into account: The risk profile of BBB Practical considerations affecting the optimum choice of gearing. marks QUESTION MARKS MRS is a large retail chain of retail stores operating in the USA. It sells topof therange, expensive clothes to a wealthy clientele throughout the country. Currently, MRS only operates in the USA. Its current market capitalisation is US$million and the current market value of debt is US $ million. At last month's management meeting the marketing director explained that sales volume had increased slightly in the previous year, largely due to heavy discounting in most of its stores. The finance director expressed concern that such a strategy might damage the image of the company and reduce profits over the longer term. An alternative strategy to increase sales volume has recently been proposed by the marketing department. This would involve introducing a new range of clothing specifically aimed at the middleincome market. The new range of clothing would be expected to be attractive to consumers in Canada and Europe, giving the possibility of opening stores in Canada and possibly Europe in the longer term. Assume you are a financial manager with MRS and have been asked to evaluate the marketing department's proposal to introduce a new range of clothing. An initial investigation into the potential markets has been undertaken by a firm of consultants at a cost of US $ but this amount has not yet been paid. It is intended to settle the amount due in three months' time. With the help of a s
QUESTION MARKS
Company BBB is one of Country Bs largest housebuilders. In BBB sold over
houses, ranging from apartment buildings to individual family houses.
Customer satisfaction is considered key to the future success of the business and the
company invests considerable resources in planning and delivering new homes to match
customer demand. Customer demand depends heavily on property prices and on both the
availability and affordability of mortgage finance.
Upfront costs for BBB are considerable. Substantial capital investment is needed between
purchasing the land for development and receiving payment for the houses. BBB therefore
requires considerable borrowings and equity funding to support its operations.
Over the last ten years, house prices have risen steadily and the housebuilding
industry has generally performed well. This has enabled BBB to reduce its
dependence on debt finance.
There has, however, been some discussion amongst Board members regarding the capital
structure of the company. Indeed, management consultants employed to review the
company's financial management have recently recommended that BBB increase its gearing
to a more efficient level. This would decrease the weighted average cost of capital WACC
and hence increase company value.
The consultants have undertaken a full review of historical financial data for both B&B and
the wider housebuilding industry and have estimated that the theoretical gearing level debt
to debt plus equity at which WACC is minimised is around for BBB
There has been some extensive debate by the Board concerning the consultants' advice.
The Finance Director, in particular, is very concerned about increasing gearing at all in the
increasingly uncertain economic climate where interest rates are forecast to rise and banks
are reluctant to provide companies with new funding.
Financial data for B&B
BBB has million ordinary $ shares in issue where $ is the currency in Country
B The shares are currently trading at $ per share. The cost of equity is
estimated to be
BBB also has the following debt finance:
$ million floating rate bank loan maturing in years' time with annual interest
set at month interbank rates plus The month interbank rate is currently
per annum.
$ million of bonds are currently trading at $ and a yield of
BBB pays corporate income tax at a rate of on taxable profits.
Required:
ai Explain the relationship between WACC and entity value. marks
ii Calculate BBBs current:
Gearing based on market values and measured as debtdebtequity
marks
WACC.
marks
iii Calculate, using Modigliani and Miller's MMs theory with tax, the
theoretical reduction in BBBs WACC if gearing were to be increased to
marks
b Evaluate the Finance Director's stated opinion that BBBs gearing should not be
increased in the current economic climate. Your answer should take into account:
The risk profile of BBB
Practical considerations affecting the optimum choice of gearing. marks
QUESTION MARKS
MRS is a large retail chain of retail stores operating in the USA. It sells topof therange,
expensive clothes to a wealthy clientele throughout the country. Currently, MRS only
operates in the USA. Its current market capitalisation is US$million and the current
market value of debt is US $ million.
At last month's management meeting the marketing director explained that sales volume
had increased slightly in the previous year, largely due to heavy discounting in most of its
stores. The finance director expressed concern that such a strategy might damage the image
of the company and reduce profits over the longer term.
An alternative strategy to increase sales volume has recently been proposed by the
marketing department. This would involve introducing a new range of clothing specifically
aimed at the middleincome market. The new range of clothing would be expected to be
attractive to consumers in Canada and Europe, giving the possibility of opening stores in
Canada and possibly Europe in the longer term.
Assume you are a financial manager with MRS and have been asked to evaluate the
marketing department's proposal to introduce a new range of clothing. An initial
investigation into the potential markets has been undertaken by a firm of consultants at a
cost of US $ but this amount has not yet been paid. It is intended to settle the amount
due in three months' time. With the help of a s
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