Question 1 Bank Overdraft MV = BV = $3,880,000 @ 5.25% (i.e., 7.50% x 0.7) Bank Loan MV = $125,000,000 @ 5.67% (i.e., 8.10% x 0.

0.7) Ordinary Shares MV = 94,200,000 shares outstanding x $1.30 = $ 122,460,000 CAPM model re= rf + e( rm rf ) = 0.041+2.0(0.06) = 0.1610 OR 16.10% BeforeTax Cost 0.0750 0.0810 0.1610 After-Tax Cost 0.0525 0.0567 0.1610 WACC= Question 2 Dividend Growth Model: re = [DPS1/price) + growth rate], where g =4.5% DPS1=$0.085 Price =$1.30 re = 0.085/1.3 +0.045 = 0.1104 The CAPM model is the better estimate as it considers market variables and company specific data such as share price. On the other hand, the dividend growth model is less reliable as it assumes that share prices will grow at a constant rate indefinitely and does not acknowledge idiosyncratic risk. Question 3 re = 0.041 + 2.3(0.06) = 0.179 BeforeTax Cost 0.075 0.081 0.179 After-Tax Cost 0.0525 0.0567 0.179 WACC =

Bank Overdrafts Bank Loans Ordinary Shares

Market Value 3880000 125000000 122460000 251340000

Weight 0.0154 0.4973 0.4872 1

Weighted Cost 0.0008 0.0282 0.0784 0.1075 0.1075

Bank Overdrafts Bank Loans Ordinary Shares

Market Value 3880000 125000000 122460000 251340000

Weight 0.0154 0.4973 0.4872 1

Weighted Cost 0.0008 0.0282 0.0872 0.1162 0.1162

Question 4 BBC's use of the industry average's equity beta of 2.3 suggests that its relative business risk for the Water Products Division is fairly similar to its competitors within the same division. However, there is potential that the capital structure is different to its competitors and should be calculated independently. Question 5 The main inconsistency behind Muds suggestion is that the beta of the division is dependent upon the beta of its competitors. Despite its competitors in the same industry having a higher ratio of net debt to net debt plus equity, the average equity beta of the divisions competitors was used. Question 6 Table 1 Forecast Year-End Free Cash Flow Spreadsheet for Water Products Division ($'000) 2010, t=0 t=1 t=2 t=3 t=4 t=5 Sales 170000 160000 176000 184800 194040 199861 Variable cost 129200 121600 133760 140448 147470 151895 Fixed cost 52000 30000 30900 31827 32782 33765 Depreciation 5700 4500 4950 5198 5457 5621 Operating income -16900 3900 6390 7328 8330 8580 Tax (30%) -5070 1170 1917 2198 2499 2574 Net income -11830 2730 4473 5129 5831 6006 Depreciation 5700 4500 4950 5198 5457 5621 Operating cash flow -6130 7230 9423 10327 11289 11627 Investment in fixed assets 0 8000 8000 8000 8000 8000 Investment in working capital -2400 -2000 3200 1760 1848 1164 Free cash flow -3730 1230 -1777 567 1441 2463

Question 7 The Horizon Value as of Year 4 can be calculated using, PVH = FCFH+1 / WACC g, where: FCFH+1 = 2463 (table 1), WACC = 0.1162 (Q3) and Growth rate (g) = 3% (Paragraph 18) PV4 = $2463/ (0.1162-0.03) = $28, 573, 000 (rounded to the nearest thousands).

Question 8 Value of the project using the WACC of 11.62%, all future cash flows (including horizon value) are discounted back to present value: ($000) Year FCF Discounted value t=1 1,230 1,102 t=2 -1,777 -1,426 t=3 567 408 t=4 1,441 928 Horizon Value 28,573 18,407 Total $19,419 Question 9 WACC minus 1% was used as the project is considered to be low risk. Table 2 Cash flow from expansion Year 1 2 3 4 NPV Upgrade -2000 250 350 2000 Discounted value -2000 225.99 286.02 1477.50 -10.47

Therefore NPV @ t1= -$10,473 Question 10 Value of the option to expand = NPV from expansion Original NPV of project = -$10473 19419 = -$29892 (rounded to the nearest thousand) Question 11 Discounted Year FCF value t= 1 1230 1102 Abandon 21000 18814 Total 19916 Value of the option to abandon= NPV from abandonment Original NPV of Project = $19916 19419 = $ 497 (rounded to the nearest thousands)

Question 12 The PV of the Water Products division is equal to the highest PV with expansion and abandonment all considered. As the PV of abandoning the Water Products division is the greatest, it is the most likely the most appropriate action taken. Therefore, the PV of the division is $19,916,000. Question 13 $'000 t=1 1230 2433.23 1485.98 947.26 282.74 0.1162 0

Cash flow PV Beginning PV End Economic depreciation Economic income Rate of return Forecast EVA

PV Beginning: 1230/(1+0.1162) -1777/(1+0.1162)^2+567/(1+0.1162)^3+1441/(1+0.1162)^4+2463/(1+0.1162)^5 PV End: -1777/(1+J30)+567/(1+J30)^2+1441/(1+J30)^3+2463/(1+J30)^4 Eco Depreciation: PV Beginning PV End 2433.23 1485.98 = 947.26 Economic Income: Cash Flow Eco. Depreciation 1230 947.26 = 282.74 Question 14 The major inadequacy of the proposed EPS hurdle is that the new EPS based on earnings after significant items and amortisation is irrelevant. It is insufficient as an indicator for EPS as the managerial expertise and skills of a manager is not reflected in the value of these items. Question 15 In recent years, we can see that there are negative cash flows for the project meaning that in the future there will be a large amount of debt that is needed to be paid for. This indicated that there is financial distress and it can be reduced by lowering debt.

Question 16 BBC should use the proceeds to repurchase shares as the WACC would be expected to decrease, increasing EPS. A dividend payment will have no effect on BBCs overall WACC. A once -off dividend payment is not advised as this generally signals to investors expectations of future increased earnings which is unsustainable. Calculations: Dividend Payment Proceeds allocated to dividend per share Current Dividend Share Repurchase Shares outstanding 000 Market Price of share Offer Received 000 Number of shares repurchased Total Number of shares after repurchase Current WACC = 0.1075 Calculated in Q1 Market Value 000 Bank Overdraft $3,880
0.016771851 0.075 0.0525

0.2123 per share 0.07 per share

94200 $1.30 $20,000 15385 78815 WACC after repurchase = 0.1028 Before-tax Cost After-tax Cost Weighted Average
0.0009

Weight

Bank Loan

$125,000

0.54033025

0.081

0.0567

0.0306

Ordinary Shares $102,460

0.442897899

0.1610

0.161

0.0713

$231,340

0.1028

Question 17 The optimal choice would be for BBC to repurchase the shares as it produces the lowest WACC and increases EPS simultaneously. By maintaining the current gearing level, BBC will also benefit by gaining a greater tax shield on debt of 125,000*8.1%*30%= 3037.5 Repayment of Loan Source of financing Bank overdraft Bank loans Ordinary shares Dividend payout WACC = 0.1075 Market value 000' $3,880 $105,000 $122,460 $231,340 Repurchase shares WACC = 0.1028 Weight 0.0168 0.4539 0.5294 1 Before-tax cost 0.075 0.081 0.1610 After-tax cost 0.0525 0.0567 0.1610 Weighted Average 0.0009 0.0257 0.0852 0.1118

Repayment of Loan WACC = 0.1118