Frances Ellen Ltd, trading as Frances Ellen has already managed 300 cafes around Australia, most of which are in holiday and tourist locations. The company is expecting to start one additional café in coming months and therefore needs a commercial kitchen with some office space as well. It has already spent $5,000 in evaluating various possible facilities and locations for the purpose. Frances Ellen Ltd has narrowed the choice to two investment options.

Option 1 involves renting a space that is already a commercial kitchen with some suitable office space attached. What is available is larger than Frances Ellen really needs, but all the essential equipment is already in place and is in good order. The terms are for a three-year lease with annual rent of $70,000. Annual insurance cost and building management fee are $3000 and $4000 respectively. This option treats annual rent, insurance and management fees as operating expenses and must be paid at the end of the year. An injection of $50,000 working capital for the life of the project would also be required at the beginning of the project.

Option 1 will generate annual cash flow of $150,000 for three years.

Option 2 involves renting a space that would need to be set to be a commercial kitchen with a small adjoining office area. This space is of an optimal size and can be rented for $52,000 per annum for three years. For option 2, equipment to the value of $25,000 would need to be purchased. Site preparation would cost $3000 and installation of the equipment would cost $2000. Thus, to have the equipment working would cost $30,000 This amount is considered a capital expenditure and needs to be depreciated to zero over 3 years. If option 2 is chosen, the total insurance would cost $12,000 (or $4000 per annum) and annual management fee is estimated to be $2,500. Like Option 1, again annual rent, insurance, and management fees are payable at the end of each year. An injection of $70,000 working capital would be required at the beginning of the project. Frances Ellen would sell the equipment at the end of the lease for $4,000. The effective corporate income tax rate is 25%.

Option 2 will generate annual cashflow of $150,000 for three years.

Capital structure of Frances Ellen Ltd

The market value of the Equity shares of Frances Ellen is estimated to be $96 million. For its financial year ended on 31st March 2021, Frances Ellen just paid a dividend of $0.48 per share. The company has observed a consistent growth rate of 6% in the most recent years, and that its shares are trading now at an average price of $7.25. Frances Ellen’s debt has three components. There is a secured loan, an unsecured loan and a placement of bonds. The secured loan is for $17.6m, with an interest rate of 4.5% compounding annually. The unsecured loan is for $4.8million with an interest rate of 7.5% per annum. Frances Ellen has on issue 25,000 bonds, each bond having a face value of $1,000. The market value of the bonds is $26.7 million with maturity in ten years. A coupon payment of $90 is paid every year while the current market is 8% per annum.

questions

6- Calculate the cost of equity 

7- Calculate the cost of bond 

8- Calculate the weighted average cost (WACC). 

9 - Which option do you recommend to Frances Ellen Ltd and Why?