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The above figures are based on the tourism industry expanding as expected. However, it is estimated that there is a 25% probability that the tourism industry will not grow as expected in the first year. If this happens, then the present value of the project’s cash flows will be 50% of the original estimates over its four-year life.
It is also estimated that if the tourism industry grows as expected in the first year, there is still a 20% probability that the expected growth will slow down in the second and subsequent years, and the present value of the project’s cash flows would then be 40% of the original estimates in each of these years.
Lumi Co, a leisure travel company, has offered $50 million to buy the project from Fugae Co at the start of the second year. Fugae Co is considering whether having this choice would add to the value of the project.
If Fugae Co is bought by Avem Co after the project has begun, it is thought that the project will not result in any additional synergy benefits and will not generate any additional value for the combined company, above any value the project has already generated for Fugae Co.
Although there is no beta for companies offering luxury forms of travel in the tourist industry, Reka Co, a listed company, offers passenger transportation services on coaches, trains and luxury vehicles. About 15% of its business is in the luxury transport market and Reka Co’s equity beta is 1·6. It is estimated that the asset beta of the non-luxury transport industry is 0·80. Reka Co’s shares are currently trading at $4·50 per share and its debt is currently trading at $105 per $100. It has 80 million shares in issue and the book value of its debt is $340 million. The debt beta is estimated to be zero.
The corporation tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4% and the market risk premium is estimated to be 6%.
(a) Discuss whether or not Nahara Co’s acquisition strategies, of pursuing risk diversification and of purchasing undervalued companies, can be valid. (7 marks)
(b) Discuss why the European Union (EU) may be concerned about Nahara Co’s stated intention and how selling Fugae Co could reduce this concern. (4 marks)
(c) Prepare a report for the Board of Directors of Avem Co, which:
Estimates the additional value created for Avem Co, if it acquires Fugae Co without considering the
luxury transport project; (10 marks)
(ii) Estimates the additional value of the luxury transport project to Fugae Co, both with and without the offer from Lumi Co; (18 marks)
Evaluates the benefit attributable to Avem Co and Fugae Co from combining the two companies with and without the project, and concludes whether or not the acquisition is beneficial. The evaluation
should include any assumptions made. (7 marks)
Professional marks will be awarded in part (c) for the format, structure and presentation of the report.
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