Question
Randolph Limited is a private company based in the UK, in the food distribution business. It is planning to expand into the retailing side of
Randolph Limited is a private company based in the UK, in the food distribution business. It is planning to expand into the retailing side of the sector for a trial period. The finance team have put together pro forma financial statements for the next four years for the retail business. These are shown below. The culmination of the food retailing project is to tie in with a large Expo event in the country taking place in four years time. The CEO of Randolph wants to be sure of the prospect of a good return on the project before going ahead with it. The project will use a mix of debt and equity funding, but the debt taken on for the project will be paid back by the end of the four years. Randolph will be able to borrow at a rate of 7%. The CEO wants a new cost of capital for the project to be estimated, as it has a different risk profile to the existing business. But, being a private company, it does not have an equity beta. However, there is a company on the stock market that very closely matches what Randolph is planning to do with the project. The company on the stock market has 40% debt funding, a debt beta of 0.25 and an equity beta of 1.63. The risk-free rate of interest is 4% and the market risk premium is 6.5%. The tax rate is 30%. Because of the reducing debt levels over the project, the CEO wants the analysis done as an adjusted present value (APV) calculation. The CEO is not sure about the amount of debt to use, but aims to borrow 190,000 for the start of the project and, with the planned debt reductions each year, the debt carried at the start of each year would be 130,000, 80,000 and 40,000, with the debt paid off in year 4. The interest on the initial 190,000 would be paid in year 1 and the interest on the 130,000 would be paid in year 2, and so on.
Q : Work out the cost of capital that you would use for the APV. ???
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