Scrooge is a Bedford-based manufacturer of high quality china and it is considering launching a new...

 

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Scrooge is a Bedford-based manufacturer of high quality china and it is considering launching a new line of products linked to Prince George and Princess Charlotte called FK&Q (acronym for future kings and queens). Its expectation is that the new line will last for the next six years. Scrooge has two alternative options. Option A: hire the factory and buy the plant; option B: buy GTH Ltd, a competitor firm (currently on sale) and allocate its entire production capability. (premises, technology, plant and human resources) to FK&Q. DATA FOR OPTION A Scrooge has to buy machinery costing 1,500,000. This machinery would have no scrap value. Scrooge's policy is to depreciate all plant and machinery on a straight line basis according to their expected life. The depreciation of the initial investment is tax-deductible. According to a market survey carried out last year at a cost of 50,000, sales units will be 40,000 in year one, 50,000 units in year two, three, four and five and then the sales are expected to decrease to 30,000 units in year six. The selling price is expected to be 45 per unit. The variable costs relating to the production are estimated to be 30 per unit and the fixed costs 100,000 a year. In addition, rent is estimated at 20,000 a year. For management accounting reasons, Scrooge allocates overheads at 5 per unit. Working capital is estimated to be 5% of variable costs. Working capital mostly comprises inventory, and so is expected to be invested/recovered at the start of the year. Tax of 20% would be levied on company profits, payable one year after the profits are made. DATA FOR OPTION B Scrooge can buy GTH Ltd that is currently on sale for 500,000 and allocate GTH Ltd to the production of the new line FK&Q. In this scenario, according to estimate, GTH Ltd will be able to produce the following stream of free cash flow 3 5 1 400,000 500,000 750,000 750,000 750,000 2 4 6 600,000 However, in year 3, an investment of 650,000 will be needed in order to refurbish part of the plant. Currently, GTH Ltd has 1,000,000 debt. GENERAL INFORMATION Scrooge is financed by debt and equity. The debt is in the form of bonds currently trading at 111.11 and due for redemption in ten years. There are 900 of these bonds. The current YTM is 8%. The Beta is 2, and the expected market return is 10%. The risk-free rate is 2%. Scrooge has 4,000 shares on which it is expected to pay a dividend of 2.00 in one year time. This dividend is expected to grow at an annual rate of 2% indefinitely. Inflation is expected to be minimal during the period, and can be ignored. Required 1. Calculate a. the company's cost of equity using the capital asset pricing model, b. the current price per share by substituting the cost of equity derived from the CAPM into the dividend growth model formula. 2. Calculate the company's gearing ratio (debt to debt plus equity) based on market values, and the company's Weighted Average Cost of Capital (WACC). 3. In order evaluate option A a. present the year-by-year cash-flow forecast, showing the tax calculation separately and then including the tax to be paid in the main cash flow forecast. calculate the Net Present Value (NPV). b 4. In order examine option B a. estimate the value of GTH Ltd when it is entirely allocated to produce FK&Q line, using the NPV approach. In a very conservative way, you should assume that the firm will have no residual value in year 7. b. Estimate the net value of GTH Ltd for Scrooge (i.e. the value created for Scrooge shareholders if it acquires GTH Ltd at the stated price. 5. By comparing the NPV of option A and option B, a state, with justification, which option you consider the best one discuss advantages/disadvantages of the two alternative options from the financial/strategic point of view. b. 6. The case you are examining considers the inflation as minimal. What are the implications when inflation is not minimal? How can you address the problem in the NPV calculations? 7. The valuation of a firm is more an art than a science. Present at least two alternative approaches for company valuation and discuss how the differences in the approaches can affect the final valuation. Scrooge is a Bedford-based manufacturer of high quality china and it is considering launching a new line of products linked to Prince George and Princess Charlotte called FK&Q (acronym for future kings and queens). Its expectation is that the new line will last for the next six years. Scrooge has two alternative options. Option A: hire the factory and buy the plant; option B: buy GTH Ltd, a competitor firm (currently on sale) and allocate its entire production capability. (premises, technology, plant and human resources) to FK&Q. DATA FOR OPTION A Scrooge has to buy machinery costing 1,500,000. This machinery would have no scrap value. Scrooge's policy is to depreciate all plant and machinery on a straight line basis according to their expected life. The depreciation of the initial investment is tax-deductible. According to a market survey carried out last year at a cost of 50,000, sales units will be 40,000 in year one, 50,000 units in year two, three, four and five and then the sales are expected to decrease to 30,000 units in year six. The selling price is expected to be 45 per unit. The variable costs relating to the production are estimated to be 30 per unit and the fixed costs 100,000 a year. In addition, rent is estimated at 20,000 a year. For management accounting reasons, Scrooge allocates overheads at 5 per unit. Working capital is estimated to be 5% of variable costs. Working capital mostly comprises inventory, and so is expected to be invested/recovered at the start of the year. Tax of 20% would be levied on company profits, payable one year after the profits are made. DATA FOR OPTION B Scrooge can buy GTH Ltd that is currently on sale for 500,000 and allocate GTH Ltd to the production of the new line FK&Q. In this scenario, according to estimate, GTH Ltd will be able to produce the following stream of free cash flow 3 5 1 400,000 500,000 750,000 750,000 750,000 2 4 6 600,000 However, in year 3, an investment of 650,000 will be needed in order to refurbish part of the plant. Currently, GTH Ltd has 1,000,000 debt. GENERAL INFORMATION Scrooge is financed by debt and equity. The debt is in the form of bonds currently trading at 111.11 and due for redemption in ten years. There are 900 of these bonds. The current YTM is 8%. The Beta is 2, and the expected market return is 10%. The risk-free rate is 2%. Scrooge has 4,000 shares on which it is expected to pay a dividend of 2.00 in one year time. This dividend is expected to grow at an annual rate of 2% indefinitely. Inflation is expected to be minimal during the period, and can be ignored. Required 1. Calculate a. the company's cost of equity using the capital asset pricing model, b. the current price per share by substituting the cost of equity derived from the CAPM into the dividend growth model formula. 2. Calculate the company's gearing ratio (debt to debt plus equity) based on market values, and the company's Weighted Average Cost of Capital (WACC). 3. In order evaluate option A a. present the year-by-year cash-flow forecast, showing the tax calculation separately and then including the tax to be paid in the main cash flow forecast. calculate the Net Present Value (NPV). b 4. In order examine option B a. estimate the value of GTH Ltd when it is entirely allocated to produce FK&Q line, using the NPV approach. In a very conservative way, you should assume that the firm will have no residual value in year 7. b. Estimate the net value of GTH Ltd for Scrooge (i.e. the value created for Scrooge shareholders if it acquires GTH Ltd at the stated price. 5. By comparing the NPV of option A and option B, a state, with justification, which option you consider the best one discuss advantages/disadvantages of the two alternative options from the financial/strategic point of view. b. 6. The case you are examining considers the inflation as minimal. What are the implications when inflation is not minimal? How can you address the problem in the NPV calculations? 7. The valuation of a firm is more an art than a science. Present at least two alternative approaches for company valuation and discuss how the differences in the approaches can affect the final valuation.

Answer rating: 100% (QA)

1 The cost of equity using the capital asset pricing model CAPM and the current price per share can be calculated as follows a The cost of equity using the CAPM can be calculated as Cost of equity Ris... View the full answer