Calculate wi’s cost of debt and wacc, Microeconomics

1.    Introduction

Wood Investments (WI) is a private equity fund that specialises in the leveraged acquisition of publicly-quoted companies with the intention of producing high returns for the fund's shareholders. It is considering a bid for Mutch PLC, a prominent UK supermarket chain.

2.    The Investment Opportunity

The motivation for the acquisition proposal is the belief, held by analysts at WI, that Mutch's earnings are currently below their potential and that a mixture of improved earnings and leveraged finance will generate a high return for WI's managers and shareholders. Mutch's Income Statement for the year ending November 2011 is shown below.

Mutch PLC Income Statement for the Year ending November 2011


£ million



Less Cost of Supplies


Less Labour Costs


Gross Operating Profit


Less Administrative Overheads


Less Other Fixed Costs


Less Depreciation


Less Net Interest


Less Tax


Net Profit


Additional Information:

1. WI has already spent £338,000 in market research, legal and consultancy fees associated with its interest in acquiring Mutch. If WI were to pursue its interest in Mutch as far as a formal bid, it is estimated that additional legal, administrative and consultancy fees would amount to £1,200,000.

2.  Mutch's sales for the year to November 2011 are 9.7 per cent below the level of two years ago. WI's analysts believe that under new ownership, Mutch's sales could recover to the level of two years ago by the end of the current year. Furthermore, the team estimates that sales revenues can subsequently grow by five per cent per annum in real terms.

3.  A consultancy report has suggested that:

  • There exists some waste in the management of supplies. Efficiency gains will mean that the 'cost of supplies' should not exceed 71 per cent of sales.
  • Mutch's current management has engaged in labour cost-cutting exercises that have compromised levels of customer service and that this has been a factor in the decline of sales. Reversing the decline requires a renewed focus on recruitment and training, with the result that 'labour costs' are likely to average 13 per cent of annual sales.
  • A takeover would require a restructuring of the company's managerial and administrative processes. As a result, 'administrative overheads' are likely to rise to £900 million for the coming year (in current cost terms). However, WI believes that they will fall by 1.5 per cent per year in absolute terms over the subsequent four years, before stabilising in real terms.
  • Improvements in Mutch's operational efficiency would release £50 million of working capital that is currently tied up in the business. This could be achieved by the end of the first year.

4.  Should WI purchase Mutch, the outstanding value of fixed assets against which capital allowances can be claimed is £1612 million in fixtures and fittings. The annual allowance is 20 per cent of a reducing balance basis. The rate of corporation tax is 26 per cent and taxes are paid one year in arrears.  

5.  Current estimates suggest that the rate of inflation will average two per cent over the next five years.

3.    The Cost of Acquiring Mutch

In recent years WI has generated an average annual (compounded) return on equity of 40 per cent before management fees. It is highly leveraged with debts of £10000 million and equity of £1000 million. If WI goes ahead with a bid for Mutch, it would continue to rely heavily on borrowing.

Unused financial commitments from shareholders amount to £2000 million. The remainder of the funds needed to buy Mutch will be borrowed. Half would be raised from a consortium of banks with which WI has financial links. The assets of Mutch would be assigned as collateral in exchange for a five-year loan at a fixed annual rate of 4.2 per cent. The other half of the debt capital would come from an issue of five-year, un-secured, fixed rate bonds. Given the highly leveraged character of the acquisition, and the absence of collateral for the bond issue, the interest rate is considerably higher. The bond issue would be assigned a BB rating by a credit-rating agency, a rating just below investment grade. The average yield on BB-rated five-year bonds is four per cent above the yield on five-year risk-free securities, which currently stands at 3.4 per cent. Legal and administrative costs associated with borrowing the funds are estimated at 1.2 per cent of the amount borrowed and would be paid immediately rather than capitalized.

Mutch's current share price is 542.75 pence. Its issued share capital amounts to 1711 million shares. WI believes that a takeover bid is almost certain to force up the price. Analysts estimate that WI will, therefore, need to offer a premium of about 15 per cent above the current share price to gain acceptance of the takeover.  

WI's high level of leverage means that its equity providers expect high returns. Though WI is not listed on a stock exchange, an analysis of the business and financial risks arising from the takeover of Mutch suggest that an appropriate equity beta is 3.8. The current risk-free return is 3.4 per cent, and the expected return on the market portfolio is 8.5 per cent.

4.    WI's Business Model

WI's business strategy involves aggressively overhauling the management of acquired companies so that a revived and restructured business can be subsequently re-floated on the stock market at a substantial premium. The aim is to re-float a company within five years of the acquisition. WI's analysts estimate that if Mutch's business revives in line with forecasts then it will have a market value in the region of £13500 million five years from now. 

3. Required

1.  Calculate WI's cost of debt, cost of equity and weighted average cost of capital (WACC) associated with a bid for Mutch

2.  Using the WACC as the discount rate, calculate the net present value of the acquisition on the basis of a five-year cash flow analysis (including the assumption that the business is sold at the end of year 5).                                                   

3.   Calculate the internal rate of return and the period of payback on the investment opportunity.

4. In the light of the results from questions two and three, discuss whether or not WI ought to proceed with the acquisition.

Discuss the risks facing WI's shareholders in the light of the scale of leverage involved in the acquisition of Mutch and the uncertainties regarding Mutch's future earnings performance.  (You should attempt to illustrate your arguments numerically on the basis of the information available).                

Posted Date: 2/20/2013 7:58:19 AM | Location : United States

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