Avem Cos acquisition interest in Fugae Co

Avem Co, a UK-based company specialising in producing and servicing business jets. Given below are extracts from the most recent statements of financial position

	Avem Co $ million
Share capital (50c/share)	800
Reserves	3,550
Non-current liabilities	2,200
Current liabilities	130
Total capital and liabilities	6,680

Each Avem Co share is currently trading at $7.50, which is a multiple of 1.5 of its dividend.

Over the past few years, the Co has paid 77.3% of its earnings as dividend, while retaining the balance for new investments. These savings can earn a return of 11% per annum.

The non-current liabilities consist entirely of $100 nominal value bonds which are redeemable in four years at the nominal value, on which the company pays a coupon of 5.4%.

Proposed luxury transport investment project by Fugae Co

In recent years, the country has been expanding its tourism industry and hopes that this industry will grow significantly in the near future. At present tourists normally travel using public transport and taxis, but there is a growing market for luxury travel. If the tourist industry does expand, then the demand for luxury travel is expected to grow rapidly. The Co is considering entering this market through a four-year project. The project will cease after four years because of increasing competition.

The initial cost of the project is expected to be $42,000,000 and it is expected to generate the following after-tax cash flows over its four-year life:

Year	1	2	3	4
Cash flows ($000s)	3,277.6	16,134.3	36,504.7	35,683.6

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 projects cash flows will be 50% of the original estimates over its four-year life.

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. Reka Cos equity beta is 1.6. Reka Cos 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.

General information

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%.

Required

1. Calculate the WACC which the company should use for investment appraisals, if no new investment is taken. (5 marks)
2. Calculate the revised WACC which the company should use for investment appraisal of investment in the tourist industry. (8 marks)
3. Using the WACC calculated in part b above, assess whether the project should be undertaken by the company or not? (12 marks)
4. Any additional information which you consider necessary for performance evaluation of projects. (5 marks)