Question

Question 1 - Capital structure

Accommodate plc is a hospitality company that owns a chain of hotels in the UK. The company is considering the acquisition of a number of fitness centres to expand its operations. The Finance Director has been asked to evaluate the project.

The investment would cost £20 million, which would be payable immediately. The investment is expected to generate pre-tax earnings of £1.2 million for the first year, £2.3 million for the second year, and £2million for each year thereafter.

The investment will be financed by 30% equity and 70% debt, which is in line with Accommodate’s existing capital structure. Due to a government initiative, some of the debt will be raised by a subsidised loan, however, the details are yet to be determined.

Accommodate’s current weighted average cost of capital (WACC) is 9%, and their pre-tax cost of debt is equal to the risk-free rate of 2%. The expected market return is currently 6%.

The Finance Director of Accommodate plc has obtained the equity and debt betas and the gearing ratio of a proxy company, for the purposes of project appraisal, these are: -

	Equity	Debt	Gearing ratio
	beta	beta	(debt: equity)
Active plc	1.2	0	1:2

Assume that the marginal rate of corporate tax is 20%.

Required:

1. Calculate the risk-adjusted WACC for Accommodate plc using Active plc as a proxy company.       

2. Calculate the NPV for the project, using the risk-adjusted WACC as the cost of capital. Suggest whether the project should be accepted.

3. Describe the benefits and limitations of using the WACC, risk-adjusted WACC and adjusted present value approaches to appraise the project. (Maximum wordcount: 240 words)

Answer 1

a. Risk-adjusted WACC =Rf+Levred beta(Rm-RF)

Levred beta =unlevred beta*(1+(1-t)(Debt/Equity)

=1.2(1+(1-.2)(1/2)

=1.68

WACC =2+1.68(6-2)

=8.72%

b. NPV of the project using Risk-adjusted WACC

Particulars	Year 1	Year2	year3
Annual cashflow	1.2m	2.3m	2m
Less: tax @20%	.24m	.46m	.4m
Cashflow after tax	.96m	1.84m	1.6
Df @8.72%	.920	.846	.778
Discounted cashflow	.8832m	1.55664m	1.2448m

NPV =DCF-outflow =3.68464m-20m=-16.31536m

It is better to reject the offer , because NPV is negetive

WACC

Advantages;

• simple and easy to calculate and understand
• The single hurdle rate for all projects
• Prompt decision making

Disadvantages:

• Difficulty in maintaining a capital structure
• It may accept a bad project and reject the good project in certain circumstances
• Difficulty in acquiring current market cost

Risk-adjusted WACC

Advantages

• Consider operating risk as well as financial risk
• Ideal rate

Disadvantages

• Complex calculation
• Difficulty in acquiring beta value

Adjusted present value

advantages

• Flexibility: ideal for the organization whose ratio of debt to equity constant
• Transparency: only looks more visible items in the assets and liabilities
• Compatible with debt repayment

Disadvantages

• Difficult in calculation
• consider only visible items in balancesheet