Question 11 - Capital structure Crocus Plc is UK retailer and is considering a large strategic investment that would involve expanding its online business. The new project is considered riskier than the current operating activities. The initial investment is 30.0 million, all of which would be payable immediately. It is expected that the investment would generate after-tax cash flows of 1.8 million in the first year, 2.6 million in the second year and 3.2 million each year thereafter. The scale of the new project is such that a significant amount of new capital will be raised. The investment will be financed 80% by equity and 20% by debt, which is in line with Crocus' existing capital structure. The board of directors of Crocus is discussing how the company should appraise the new investment. There is a difference of opinion on whether the firm's current WACC of 7% should be used to appraise the project, or whether risk-adjusted WACC or Adjusted Present Value (APV) should be used instead. The Finance Director has obtained the betas and debt ratio of a proxy company, Online Fashion Plc. These are: Equity Debt Debt ratio Beta Beta (debt: equity) 1:2 Online Fashion Plc 2.2 0 The expected market return is 7% and Crocus can borrow at the risk-free rate of 2%. Assume that the corporation tax rate is 19%. Required: a) Calculate the risk-adjusted WACC for Crocus Plc using Online Fashion Plc as a proxy company. b) Calculate the NPV of the project using the risk-adjusted WACC and conclude whether the project should be accepted. c) Comment on the appropriateness of using the current WACC, risk- adjusted WACC and APV approaches to appraise the project. (5 MASI Question 11 - Capital structure Crocus Plc is UK retailer and is considering a large strategic investment that would involve expanding its online business. The new project is considered riskier than the current operating activities. The initial investment is 30.0 million, all of which would be payable immediately. It is expected that the investment would generate after-tax cash flows of 1.8 million in the first year, 2.6 million in the second year and 3.2 million each year thereafter. The scale of the new project is such that a significant amount of new capital will be raised. The investment will be financed 80% by equity and 20% by debt, which is in line with Crocus' existing capital structure. The board of directors of Crocus is discussing how the company should appraise the new investment. There is a difference of opinion on whether the firm's current WACC of 7% should be used to appraise the project, or whether risk-adjusted WACC or Adjusted Present Value (APV) should be used instead. The Finance Director has obtained the betas and debt ratio of a proxy company, Online Fashion Plc. These are: Equity Debt Debt ratio Beta Beta (debt: equity) 1:2 Online Fashion Plc 2.2 0 The expected market return is 7% and Crocus can borrow at the risk-free rate of 2%. Assume that the corporation tax rate is 19%. Required: a) Calculate the risk-adjusted WACC for Crocus Plc using Online Fashion Plc as a proxy company. b) Calculate the NPV of the project using the risk-adjusted WACC and conclude whether the project should be accepted. c) Comment on the appropriateness of using the current WACC, risk- adjusted WACC and APV approaches to appraise the project. (5 MASI
