Problems
(Problems 14.1 and 14.2 are basic-level problems, whereas problems 14.3 and 14.4 are
more advanced and may contain some practical complications.)14.1*ABB plc has a cost of capital of 20 per cent p.a., and it is expected to generate annual
end-of-year cash inflows of £12 million a year forever.
The capital projects department has identified a smaller business, CDD Ltd, which
it is believed would be a suitable takeover target for ABB plc. It is estimated that the
combined operation would have a perpetual end-of-year cash inflow of £14 million.
ABB plc’s capital projects department analysts estimate that it would be worth the
business paying up to £27.5 million to acquire the entire equity of CDD Ltd.
What cost of capital must the analysts have estimated for the combined operation?
(Ignore taxation.)14.2 Taking the same circumstances as in Problem 14.1, without the takeover CDD Ltd
had expected annual end-of-year cash inflows of £1.5 million forever, and an estim-
ated cost of capital of 18 per cent p.a.
What is the minimum that the shareholders of CDD Ltd should logically accept for their
shares in the takeover?
Logically, what should be the finally agreed total price for CDD Ltd’s equity?14.3*Thruster plc is a dynamic, expanding business. Relaxation plc is a solid but unam-
bitious one operating in the same industry. Thruster plc has recently launched a
takeover bid for Relaxation plc. The offer is that Thruster plc will give one of its shares
to shareholders in Relaxation plc for every three of their shares.
After-tax cost savings are estimated to be £8 million p.a. as a result of administrat-
ive efficiencies, compared with the total costs historically incurred by the two busi-
nesses. Summarised financial statements for the two businesses for the year just
ended are as follows:Income statement
Thruster plc Relaxation plc
£m £m
Turnover 650 200
Profit before tax 72 17
Taxation 24 6
Profit after tax 48 11
Dividends paid 7 5PROBLEMS
Sample answers to
problems marked with
an asterisk appear in
Appendix 4.
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