ACCA AFM Syllabus B. Advanced Investment Appraisal - Debt or Equity? - Past Papers ^{1 / 19}

Makonis Co, a listed company producing motor cars, wants to acquire Nuvola Co, an engineering company involved in producing innovative devices for cars. Makonis Co is keen to incorporate some of Nuvola Co’s innovative devices into its cars and thereby boosting sales revenue.

The following financial information is provided for the two companies:

Makonis Co
Current share price $5•80 
Number of issued shares 210 million 
Equity beta 1•2 
Asset beta 0•9

Nuvola Co
Current share price $2.40 
Number of issued shares 200 million 
Equity beta 1•2 
Asset beta 1.2

It is thought that combining the two companies will result in several benefits. Free cash flows to firm of the combined company will be $216 million in current value terms, but these will increase by an annual growth rate of 5% for the next four years, before reverting to an annual growth rate of 2•25% in perpetuity. In addition to this, combining the companies will result in cash synergy benefits of $20 million per year, for the next four years. These synergy benefits are not subject to any inflationary increase and no synergy benefits will occur after the fourth year. The debt-to-equity ratio of the combined company will be 40:60 in market value terms and it is expected that the combined company’s cost of debt will be 4•55%.

The corporation tax rate is 20%, the current risk free rate of return is 2% and the market risk premium is 7%. It can be assumed that the combined company’s asset beta is the weighted average of Makonis Co’s and Nuvola Co’s asset betas, weighted by their current market values.

Makonis Co has offered to acquire Nuvola Co through a mixed offer of one of its shares for two Nuvola Co shares plus a cash payment, such that a 30% premium is paid for the acquisition. Nuvola Co’s equity holders feel that a 50% premium would be more acceptable. Makonis Co has sufficient cash reserves if the premium is 30%, but not if it is 50%.

Required:

Estimate the additional funds required if a premium of 50% is paid instead of 30% and discuss how this premium could be financed. (7 marks)

Sembilan Co, a listed company, recently issued debt finance to acquire assets in order to increase its activity levels. This debt finance is in the form of a floating rate bond, with a face value of $320 million, redeemable in four years. The bond interest, payable annually, is based on the spot yield curve plus 60 basis points. The next annual payment is due at the end of year one.

Sembilan Co is concerned that the expected rise in interest rates over the coming few years would make it increasingly difficult to pay the interest due. It is therefore proposing to either swap the floating rate interest payment to a fixed rate payment, or to raise new equity capital and use that to pay off the floating rate bond. The new equity capital would either be issued as rights to the existing shareholders or as shares to new shareholders.

Ratus Bank has offered Sembilan Co an interest rate swap, whereby Sembilan Co would pay Ratus Bank interest based on an equivalent fixed annual rate of 3•76¼% in exchange for receiving a variable amount based on the current yield curve rate. Payments and receipts will be made at the end of each year, for the next four years. Ratus Bank will charge an annual fee of 20 basis points if the swap is agreed.

The current annual spot yield curve rates are as follows:

The current annual forward rates for years two, three and four are as follows:

Required:

Discuss the factors that Sembilan Co should consider when deciding whether it should raise equity capital to pay off the floating rate debt. (9 marks)