Question

Gobin plc is a furniture manufacturer in the located in Scotland and trading on the London Stock Exchange. The firm has a beta of 1.2. The historical rate of return on the FTSE All-Share index (i.e., the market portfolio) is 14% and the risk-free rate of return in the United Kingdom is currently at 6%. Managers at Gobin plc are planning to issue corporate bonds with a rate of 7.20%. The market value of the bonds is £250 million and the bonds will be issued at par. Gobin’s stock, of which 25 million shares are outstanding, sells for £30 per share. The UK corporate tax rate is 10%.

(a) Calculate (i) Gobin’s cost of equity, and (ii) after-tax weighted average cost of capital (WACC)

(b) Managers at Gobin plc must decide whether or not to purchase additional capital equipment. The cost of the equipment is £9 million to be paid upfront (today). The expected after-tax cash flows from the new equipment are £3 million a year for the first 4 years, £0.5 million in the fifth year, £0 million in the sixth year and £0.1 million a year for the 10 years that follow (i.e., from year 7 to year 16). The salvage value of this equipment is zero. Assume that all after-tax cash flows occur at the end of the year. You are required to (i) demonstrate by calculation, whether Gobin plc should purchase the new equipment, and (ii) briefly explain how an increase in the UK corporate tax rate from 10% to 30% might impact on the suitability of the project.

Answer 1

a) (i) Gobin’s cost of equity :

Cost of Equity (Ke) can be computed using CAPM which captures the total risk involved.

  

Where Re = Required rate of return from the investment

Rf = Risk free rate of return

B = Beta value of the investment

Rm = Expected return from the market portfolio

Therefore Ke= 6%+ 1.2(14-6)

= 15.6%

(ii) after-tax weighted average cost of capital (WACC)

Where : Ke = Cost of Equity

Kd(1-T)= Cost of Debt (post tax)

Ve= Market value of equity

Vd = Market value of Debt

WACC = {(25*30)/1000}15.6% + {250/1000}7.2(1-.1)

=13.32%

B) i) Whether Gobin plc should purchase the new equipment :

The feasibility of the project can be assessed by calculating the net present value of the project :

NPV Calculation

Year	Cashflows (in millions)	DF @ 13.32%	Present Value
0	-9	1	-9
1	3	0.8825	2.6474
2	3	0.7787	2.3362
3	3	0.6872	2.0616
4	3	0.6064	1.8193
5	0.5	0.5351	0.2676
6	0	0.4722	0
7	0.1	0.4167	0.0417
8	0.1	0.3677	0.0368
9	0.1	0.3245	0.0325
10	0.1	0.2864	0.0286
11	0.1	0.2527	0.0253
12	0.1	0.2230	0.0223
13	0.1	0.1968	0.0197
14	0.1	0.1737	0.0174
15	0.1	0.1533	0.0153
16	0.1	0.1352	0.0135

NPV of the Project = Sum of all cashflows discounted at WACC

= 0.3850 million

Since NPV of the project is positive, the purchase of the equipment is financially viable.

(ii) briefly explain how an increase in the UK corporate tax rate from 10% to 30% might impact on the suitability of the project.

Revised WACC = {25*30/1000}*15.6% + {250/1000}7.2%(1-.3)

= 12.96%

Formula for NPV ; NPV = (Cash flows)/( 1+r)i

Where ; i= Initial Investment

Cash flows= Cash flows in the time period

r = Discount rate

i = time period

NPV = 4.5/(1+.1296)^16

= 0.4643 million

Since NPV of the project is positive, the purchase of the equipment is financially viable.