Donals plc is a listed company in the cloth retailing sector and has large stores in all the major cities in the UK. Donals' board is considering diversifying by opening restaurants in all of its stores. At a recent board meeting the directors were discussing how the restaurant project should be appraised. One director insisted that Donals' current weighted average cost of capital should be used to evaluate the project as the majority of its operations will still be in cloth retailing. The finance director disagreed because the existing cost of equity is not consistent with the systematic risk of the new project. The finance director also said that the company's overall WACC, which reflects all of the company's activities, would change as a result of the new project. The board were also concerned about the market's reaction to their diversification plans. The board decided to raise the capital required for the restaurant project in such a way as to leave its existing debt/equity ratio (by market value) unchanged. Extracts from Donals' most recent management accounts are shown below

Balance sheet at the end of 20x0

At the end of 20x0, Donals' ordinary shares had a market value of $2.80 (ex-div) and an equity beta of 0.8. The dividend yield was 5% and the earnings per share were $0.2. The return on the market is expected to be 9% pa and the risk free rate 3% pa. Donals' debentures had a market value of $105(ex-interest) per $100 nominal value at the end of 20x0 and they are redeemable at par at the end of 20x3.

Companies operating solely in the restaurant industry have an average equity beta of 1.5 and an average debt/equity ratio (by market value) of 3:5. It has been estimated that if the project goes ahead the overall equity beta of Donals will be made up of 85% cloth retailing and 15% restaurants. Assume that the corporation tax rate will be 30% pa for the foreseeable future.

Required:

1)Ignoring the new project, calculate the cost of equity capital of Donals using:

a)The CAPM.

b)The Gordon growth model.

2)Ignoring the new projects, calculate Donals' after-tax cost of debt capital.3)Ignoring the new projects, calculate Donals' WACC (please use the cost of equity capital estimated with the CAPM)

4)Using the CAPM, calculate the cost of equity that should be included in a WACC suitable for appraising the project and explain your reasoning.

Balance sheet at the end of 20x0 Ordinary share capital ($0.1 per share) Retained earnings 6% redeemable bonds at nominal value (redeemable 2000 20x3] Ch 0 0 Long term bank loans (interest rate 4%)