Question 1 - Capital structure

Accommodate plc is a hospitality company that owns a chain of hotels in the UK. The company is considering the acquisition of a number of fitness centres to expand its operations. The Finance Director has been asked to evaluate the project.

The investment would cost 20 million, which would be payable immediately. The investment is expected to generate pre-tax earnings of 1.2 million for the first year, 2.3 million for the second year, and 2million for each year thereafter.

The investment will be financed by 30% equity and 70% debt, which is in line with Accommodates existing capital structure. Due to a government initiative, some of the debt will be raised by a subsidised loan, however, the details are yet to be determined.

Accommodates current weighted average cost of capital (WACC) is 9%, and their pre-tax cost of debt is equal to the risk-free rate of 2%. The expected market return is currently 6%.

The Finance Director of Accommodate plc has obtained the equity and debt betas and the gearing ratio of a proxy company, for the purposes of project appraisal, these are: -

	Equity	Debt	Gearing ratio
	beta	beta	(debt: equity)
Active plc	1.2	0	1:2

Assume that the marginal rate of corporate tax is 20%.

Required:

1. Calculate the risk-adjusted WACC for Accommodate plc using Active plc as a proxy company.

(10 marks)

2. Calculate the NPV for the project, using the risk-adjusted WACC as the cost of capital. Suggest whether the project should be accepted.

(3 marks)

3. Describe the benefits and limitations of using the WACC, risk-adjusted WACC and adjusted present value approaches to appraise the project. (Maximum wordcount: 240 words)

(12 marks)