Question 4

(a) Show how to derive formulae for the WACC under the Hamada (1972) and Miles and

Ezzell (1980) models. Explain clearly the assumptions made in the derivation of both

models.

(35 marks)

(b) Critically compare the weighted average cost of capital (WACC) and the adjusted

present value (APV). Fully explain their strengths and weaknesses.

(25 marks)

(c) Clifton plc, a company in the hotel sector is evaluating the acquisition of an organic

restaurant chain, Loaf plc. Clifton plc assumes Loaf plc is of approximately the same

business risk as Gerard plc, which has a debt-to-equity ratio (D/E) of 0.25 and an equity

beta of 1.15.

Clifton plc will acquire Loaf plc for 250 million, and Loaf plc is expected to return 35

million per annum in perpetuity with the first cash flow arising one year from now.

Assume that Loaf plc will be purchased with a fixed perpetual amount of debt of 125

million and the balance will be funded by equity, thereby maintaining Clifton plcs debtto-equity ratio (D/E) of roughly 50%.

Both the risk-free rate and the required return on debt are 5%, the expected return on

the market portfolio is 10% and the rate of corporation tax is 30%.

REQUIRED:

(i) Compute a suitable equity beta for Loaf plc using the Hamada model. Assuming

that debt is risk free, compute a suitable weighted average cost of capital (WACC)

and calculate the net present value (NPV) of the proposed acquisition.

(20 marks)

(ii) Calculate the present value of the tax shield. Evaluate the project via the adjusted

present value (APV) method by adding the tax shield to the value of the acquisition

as if all equity finance.

(5 marks)

(d) Explain when strategic options are useful in project evaluation. Your answer should

include a brief discussion of options to delay and option to expand.

(15 marks)

[Total 100 marks]