SECTION C: QUESTION THREE

Deli Delight Plc is a chain of shops specialising in the sale of savoury foods. Due to its success it is proposing to expand its business. There are two proposals under consideration. The first proposal involves increasing the number of Deli Delight shops by moving into towns and cities where they do not have a presence. These enterprises will be run on a similar basis to the current outlets. The second proposal involves opening caf bars, in close proximity to current outlets, such that their own food products can be included on the menu by way of marketing. This represents a change of business for the company.

The company needs to evaluate their current cost of capital but there is discussion as to what rate to use and if one overall figure is suitable for both proposals.

Deli Delight Plc has 20 million of 1 nominal value ordinary shares and the current share price for each share is 2.35 ex div. In addition, the company has 10 million (book value) of 8% convertible debentures (secured on property), which are currently trading at 96 each. Each 100 debenture will be redeemed in five years time for 114.36.

Deli Delight Plc has an equity beta of 1.25, which is representative of the current industry. The average gearing (debt:equity) of this industry in market value terms is 25:75. The caf bar industry sector has an average beta of 1.8 and an average gearing in market value terms of 20:80. Deli Delight Plc will maintain its current capital structure after the business expansion.

The equity risk premium has been estimated to be 5.8% and treasury bills are currently offering 3%. Corporate tax is 19%.

REQUIRED

1. Calculate a suitable discount rate to be used to expand the existing number of outlets.

(8 marks)

2. Calculate a suitable discount rate to be used to appraise the diversification into caf bars.

(6 marks)

3. In addressing the query regarding the cost of capital, explain your choice of discount rate for each proposal and explain why no adjustments are made with regard to debt.

(6 marks)