QUESTION $1[25$ MARKS$]$

Company BBB is one of Country B$\text{'}$s largest house$-$builders. In $2015,$ BBB sold over $9000$

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.

Up$-$front 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 house$-$building

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 house$-$building industry and have estimated that the theoretical gearing level $($debt

to debt plus equity$)$ at which WACC is minimised is around $60\%$ 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 $150$ million ordinary $B$$$1$ shares in issue $($where $B$$ is the currency in Country

B$).$ The shares are currently trading at $B$$$12\mathrm{.}83$ per share. The cost of equity is

estimated to be $8\%.$

BBB also has the following debt finance:

$B$$$300$ million floating rate bank loan maturing in $8$ years' time with annual interest

set at $12$ month interbank rates plus $2\%.$ The $12$ month interbank rate is currently

$3\%$ per annum.

$B$$$500$ million of bonds are currently trading at $B$$$105$ and a yield of $5\%.$

BBB pays corporate income tax at a rate of $33\%$ on taxable profits.

Required:

$($a$)($i$)$ Explain the relationship between WACC and entity value. $[3$ marks$]$

$($ii$)$ Calculate BBB$\text{'}$s current:

Gearing $($based on market values and measured as debt$/$debt$+$equity$).[2$

marks$]$

WACC.

$[3$ marks$]$

$($iii$)$ Calculate, using Modigliani and Miller's $($MM$\text{'}$s$)$ theory with tax, the

theoretical reduction in BBB$\text{'}$s WACC if gearing were to be increased to

$60\%.$

$[6$ marks$]$

$($b$)$ Evaluate the Finance Director's stated opinion that BBB$\text{'}$s 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.$[11$ marks$]$

QUESTION $2[25$ MARKS$]$

MRS is a large retail chain of retail stores operating in the USA. It sells top$-$of the$-$range,

expensive clothes to a wealthy clientele throughout the country. Currently, MRS only

operates in the USA. Its current market capitalisation is US$$760$million and the current

market value of debt is US $$350$ 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 middle$-$income 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 $$100,000$ 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