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Hi,
I worked out Qn. 83 from Bpp Kit (Laceto Inc) and found out that the model answer uses $19m as the post takeover cash flows after 20X5. In my thinking, the cash flow in year 20X5 should be $32m and not the $19m which is the present value in year 20X5.
I’ll be grateful for you advice on the choice taken by Bpp model answers.
Thanks.
DavidYou can either take the flow of 32M, discount it as a perpetuity, and then discount for 4 years since it starts 4 years later.
Alternatively, you can get the same answer doing it in another order – discount by 4 years first and then discount as a perpetuity (which is what BPP do).
Many thanks John. However, looking through, I noticed BPP has error in discounting the present value, $19m is already discounted, discounting again by 0.592 leads to double discounting.
On another note, would it be proper to get the average of the gearing ratio 20.5% (18+23)/2, instead of using gearing at 18% and 23% separately.
Thanks.
I don’t have the BPP answer, but I am guessing that they have not made an error.
19.1 is indeed the present value of the cash flow after discounting for 4 years. However we need to discount a perpetuity of 32.3 from 5 to infinity with inflation of 3%.
Having discounted for 4 years (because the perpetuity starts 4 years late – at time 5 instead of time 1) it can then be treated as a normal perpetuity and the dividend growth formula can be used.
With growth at 3% and a cost of capital of 14% this gives:
(19.1 x 1.03) / (0.14 – 0.03) = $179MThere is more than one way of arriving at this, but if BPP have ended up with $179M and a final NPV of 78.6 then they are correct.
Yes – it would have been OK to use the average gearing ratio. Looking at the two separately is better because the question asked for a range of values. However as it turns out both gearing ratios end up giving a very similar WACC and so it doesn’t really matter here.
Ho John
On this same question, in the bpp solution, please advise where the interest amount of 10% is derived from in the post acquisition interest amount? In the question it says that Laceto’s loan stock is 12%
Plus, when a company acquires a company with a lower gearing level, will the cost of debt always remain the same as the acquirers cost of debt pre acquisition (as stated in said bpp solution)?
Thanks
Maybe I am missing something, but I am puzzled where you are seeing interest of 10%.
The cost of debt is 5.2%. 12% is the coupon rate – the cost to the company is currently 5.2% and it is assumed to stay at that.
BPP do not say that the cost of debt will always remain the same. In fact, it might fall if they are acquiring a company with lower gearing. However, it would be unlikely to rise, and they are assuming that it stays the same. There is nothing else that we can do here but assume that it stays the same.
Hello
I am also studying this question and I was wondering, when we calculate value of shares (part a, i), we take 77% and 82%. Why is this? I see that it is connected with gearing 18 and 23%, but can you help me understand this?
If this kind of question would repeat on the exam, how do we know how much different values we have to calculate? If I would use current market price, realizable values and PE, but not CF, how much points can I expect?
Thank you
As I have previously written, I do not have the question Laceto (it is not in the current edition of the BPP Revision Kit).
However I would guess that 77% is because 100 – 23 = 77, and 82% is because 100 – 18 = 82.
I cannot answer the rest of your question because I do not have the original question.
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