SECTION E: QUESTION FIVE

Bark Plc is an all-equity company that manufactures grooming products for animals. It has enjoyed a period of growth and success, but it is now considering changing direction. The proposal currently being considered is to invest in an opportunity that provides animal grooming services it will be called Peticure. The first stage of the expansion will see five outlets being opened. Preliminary market research costing 35,000 has been undertaken and has provided the following costings and projections.

Investment cost will be 13,500,000. Net income after tax in the first year, is forecast to be 2,000,000, rising by 3% per year, for five years. It is thought that sales of grooming products will also benefit from being sold in the new outlets with incremental after tax cashflows being estimated at 300,000 in year 1 and rising by 4% each year after that.

The pet grooming services industry has two dominant providers: KitCat Plc and Tweet Plc. KitCat Plc has an equity beta of 1.3 and a capital structure (Equity to Debt) in market value terms of 70:30. Tweet Plc, has an equity beta of 1.6 and a capital structure (Equity to Debt) in market value terms of 60:40.

The expansion will be funded using a combination of equity and debt. 7,500,000 will be raised by a rights issue (which will incur non tax-deductible net issue costs of 2.5%). The remaining 6,000,000 will be raised by borrowing. 4,000,000 will be provided by loan at the current normal rate for the company of 11%. The remainder will be at a subsidised rate providing a 4% saving on the current normal rate. Net issue costs relating to all of the borrowing are 1.5% and are also non tax-deductible.

The FTSE All Share index is currently offering returns of 11% and treasury bills are yielding 3%. Bark Plc currently has 40,000,000 shares in issue each trading at 1.32. The Bark Plcs beta is 0.8 and its cost of capital is 9.4%. Corporation tax is 19%.

REQUIRED

1. Critically discuss the appropriate method of investment appraisal that should be used for Bark Plcs proposed expansion.

(7 marks)

2. Evaluate the proposed expansion using the appropriate method. Advise Bark Plc on whether it should proceed with the project.

(13 marks)