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1 / 9

SECTION A: THIS QUESTION is compulsory and MUST be attempted



Naomi Co, an unlisted company, designs and develops tools and parts for specialist machinery. The company was formed 4 years ago by 3 friends, who own 20% of the equity capital in total, and a consortium of 5 business angel organisations, which own the remaining 80%, in roughly equal proportions. Naomi Co also has a large amount of debt finance in the form of variable rate loans. Initially the amount of annual interest payable on these loans was low and allowed Naomi Co to invest internally generated funds to expand its business. Recently, though, due to a rapid increase in interest rates, there has been limited scope for future expansion and no new product development.

The board of directors, consisting of the three friends and a representative from each business angel organisation, met recently to discuss how to secure the company's future prospects. Two proposals were put forward, as follows:


Proposal 1

To accept a takeover offer from Mint Co, a listed company, which develops and manufactures specialist machinery tools and parts. The takeover offer is for $2.95 cash per share or a share-for-share exchange where two Mint Co shares would be offered for three Naomi Co shares. Mint Co would need to get the final approval from its shareholders if either offer is accepted.


Proposal 2

To pursue an opportunity to develop a small prototype product that just breaks even financially, but gives the company exclusive rights to produce a follow-on product within two years. The meeting concluded without agreement on which proposal to pursue.

After the meeting, Mint Co was consulted about the exclusive rights. Mint Co's directors indicated that they had not considered the rights in their computations and were willing to continue with the takeover offer on the same terms without them.

Currently, Mint Co has 10 million shares in issue and these are trading for $4.80 each. Mint Co's price/earnings (P/E) ratio is 15. It has sufficient cash to pay for Naomi Co's equity and a substantial proportion of its debt, and believes that this will enable Naomi Co to operate on a P/E level of 15 as well. In addition to this, Mint Co believes that it can find cost-based synergies of $150,000 after tax per year for the foreseeable future. Mint Co's current profit after tax is $3,200,000.

The following financial information relates to Naomi Co and to the development of the new product.


Naomi Co financial information


Sales revenue 8,780
Profit before interest and tax 1,230
Interest (455)
Tax (155)
Profit after tax 620
Dividends Nil



Net non-current assets 10,060
Current assets 690


Total assets 10,750
Share capital (40c per share par value) 960
Reserves 1,400
­­­Non-current liabilities: Variable rate loans 6,500
Current liabilities 1,890


Total liabilities and capital 10,750


In arriving at the profit after tax amount, Naomi Co deducted tax-allowable depreciation and other non-cash expenses totalling $1,206,000. It requires an annual cash investment of $1,010,000 in non-current assets and working capital to continue its operations.

Naomi Co's profits before interest and tax in its first year of operation were $970,000 and have been growing steadily in each of the following three years, to their current level. Naomi Co's cash flows grew at the same rate as well, but it is likely that this growth rate will reduce to 25% of the original rate for the foreseeable future.

Naomi Co currently pays interest of 7% per year on its loans, which is 380 basis points over the government base rate, and corporation tax of 20% on profits after interest. It is estimated that an overall cost of capital of 11% is reasonable compensation for the risk undertaken on an investment of this nature.


New product development (Proposal 2)

Developing the new follow-on product will require an investment of $2,500,000 initially. The total expected cash flows and present values of the product over its 5-year life, with a volatility of 42% standard deviation, are as follows:


Year(s) Now (total) 1 2 3 to 7
Cash flows ($'000) (2,500) 3,950
Present values ($'000) (2,029) 2,434



a. Prepare a report for the board of directors of Naomi Co that:


i. Estimates the current value of a Naomi Co share, using the free cash flow to firm methodology

(7 marks)


ii. Estimates the percentage gain in value to a Naomi Co share and a Mint Co share under each payment offer

(8 marks)


iii. Estimates the percentage gain in the value of the follow-on product to a Naomi Co share, based on its cash flows and on the assumption that the production can be delayed following acquisition of the exclusive rights of production.

(8 marks)


iv. Discusses the likely reaction of Naomi Co and Mint Co shareholders to the takeover offer, including the assumptions made in the estimates above and how the follow-on product's value can be utilised by Naomi Co.

(8 marks)

Professional marks will be awarded for the presentation, structure and clarity of the answer.

(4 marks)

2 / 9

b. Evaluate the current performance of Naomi Co and comment on what this will mean for the proposed takeover bid.

(8 marks)

3 / 9

c. Since the approach to Naomi Co, Mint Co has itself been the subject of a takeover bid from Tiger Co, a listed company which specialises in supplying machinery to the manufacturing sector and has a market capitalisation of $245 million.



Evaluate the general post-bid defences and comment on their suitability for Mint Co to try to prevent the takeover from Tiger Co.

(7 marks)

4 / 9




Damro is a furniture manufacturer based in the UK. It manufactures a limited range of furniture products to a very high quality and sells to a small number of retail outlets worldwide.

At a recent meeting with one of its major customers it became clear that the market is changing and the final consumer of Damro's products is now more interested in variety and choice rather than exclusivity and exceptional quality.

Damro is therefore reviewing two mutually exclusive alternatives to apply to a selection of its products:


Alternative 1

To continue to manufacture, but expand its product range and reduce its quality. The net present value (NPV), internal rate of return (IRR) and modified internal rate of return (MIRR) for this alternative have already been calculated as follows:

NPV = £1.45 million using a nominal discount rate of 9%
IRR = 10.5%MIRR Approximately = 13.2%
Payback = 2.6 years Discounted payback = 3.05 years


Alternative 2

To import furniture carcasses in 'flat packs' from the US. The imports would be in a variety of types of wood and unvarnished. Damro would buy in bulk from its US suppliers, assemble and varnish the furniture and resell, mainly to existing customers. An initial investigation into potential sources of supply and costs of transportation has already been carried out by a consultancy entity at a cost of £75,000. Damro's finance director has provided estimates of net sterling and US$ cash flows for this alternative. These net cash flows, in real terms, are shown below.

Year 0 1 2 3
US $m (25.00) 2.60 3.80 4.10
£m 0 3.70 4.20 4.60


The following information is relevant:

  • Damro evaluates all its investments using nominal sterling cash flows and a nominal discount rate. All non-UK customers are invoiced in US$. US$ nominal cash flows are converted to sterling at the forecast rate (see below) and discounted at the UK nominal rate.
  • For the purposes of evaluation, assume the entity has a three-year time horizon for investment appraisals.
  • Based on recent economic forecasts, inflation rates in the US are expected to be constant at 4% per annum. UK inflation rates are expected to be 3% per annum.
  • The current exchange rate is £1 = US$1.6.
Year 0 1 2 3
Exchange rate forecast US$/£ 1.600 1.616 1.631 1.647


Note. Ignore taxation. Convert.



Assume you are the financial manager of Damro.

a. Evaluate Alternative 2, using NPV, discounted payback, IRR and the (approximate) MIRR.

(11 marks)

5 / 9

b. Calculate the project duration for Alternative 2 and discuss the significance of your results if you are told that the duration for Alternative 1 is 3.2 years.

(4 marks)

6 / 9

c. Evaluate the two alternatives and recommend which alternative the entity should choose.

Include in your answer a discussion about what other criteria should be considered before a final decision is taken.

(10 marks)

7 / 9


Laughs, a public limited company with a market value of around £7 billion, is a major supplier of gas to both business and domestic customers. The company also provides maintenance contracts for both gas and central heating customers using the well-known brand name Gas For All. Customers can call emergency lines for assistance with any gas-related incident, such as a suspected leak. Laughs employs its own highly trained workforce to deal with all such situations quickly and effectively. The company also operates a major new credit card, which has been extensively marketed and which gives users concessions, such as reductions in their gas bills.

Laughs has recently bid £1.1 billion for CarCare, a long-established mutual organisation (ie it is owned by its members) that is the country's leading motoring organisation. CarCare is financed primarily by an annual subscription to its 4.4 million members. In addition, the organisation obtains income from a range of other activities, such as a high profile car insurance brokerage, a travel agency and assistance with all types of travel arrangements. Its main service to members is the provision of a roadside breakdown service, which is now an extremely competitive market with many other companies involved. Although many of its competitors use local garages to deal with breakdowns, CarCare uses its own road patrols.

CarCare members have to approve the takeover, which once completed would provide them each with a windfall of around £300 each.

Laughs intends to preserve the CarCare name which is extremely well known to consumers.



a. Discuss the possible reasons why Laughs is seeking to buy CarCare.

(9 marks)

8 / 9

b. Discuss how the various stakeholders of CarCare might react to the takeover.

(8 marks)

9 / 9

c. Discuss the potential problems that Laughs may face in running CarCare now that the takeover has been achieved.

(8 marks)

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