It is expected that the City Centre showroom will increase the overall sales revenue of the
company by 10% per annum from 2020, and the variable cost will be forty-two percent of sales
revenue. The fixed overhead cost will be £3,500,000, £2,000,000 and £1,500,000 in the first,
second, and third years. The promotion cost will be £500,000 in the first two years and
£200,000 for the next three years. All other expenses will be 10% of the total contribution
margin. In the second year, the company will need a working capital investment of £2 million,
and 60% of which will recover at the end of project life. The company follows a straight-line
depreciation method and expects to sell the assets at 20 % of historical cost in year 5.
Option two: Clifton Moor
On the other hand, if the showroom is opened at Clifton Moor, then it will require fixed
overhead cost for four years £2,500,000 in year one, £1,800,000 in year three, £2,100,000 in
year four and £1,100,000 in year five. All other costs will increase and be at 10% per year of the
contribution margin. The working capital investment will be £1,500,000 in year three, and 55%
of it will recover in the last year. The sales revenue will increase at 12% per annum, and variable
cost will be 45% of sales. The company will follow a similar strategy for depreciation and
promotional cost, just like the city centre.
Financing the investment
The company has several choices for financing this expansion – issuing new equity or bond or
using existing retained earnings. The shares of Daffodil are traded in the Alternative Investment
Markets (AIM) for £30, however, the face value is £20 and last year’s dividend was £0.35.
HSBC will charge a flotation cost of 10% to issue the new common stock in the market. There
is a projection that the dividend will grow at 6% a year in the coming years. The firm can issue
an additional long-term bond at an interest rate (before tax) of 10 % (i.e. Coupon rate).
Currently, similar bonds are selling at £110, slightly over the face value (which is £100), with
five years of maturity. The market risk premium is 5%, the 3-month UK gilt rate is 3.5% (riskfree rate), and the average Beta of the Electronic goods industry is 1.73.
The company is also planning to issue preferred stocks. The industry average preferred dividend
and current market price are £10 and £96, respectively. The company wants to maintain a
capital structure of approximately 45% debt, 5% preferred equity and 50% of ordinary equity.
The current corporate tax rate is 35%.
Page | 5
Required
a) Determine the Weighted Average Cost of Capital (WACC) for target capital structure.
b) Evaluate which showroom should be selected (Hints: use NPV and IRR). Ms Victoria prefers
to use CAPM (i.e., Capital Asset Pricing Model) over DDM (i.e., Dividend Discount
Answers
Answer:
It is expected that the City Centre showroom will increase the overall sales revenue of the
company by 10% per annum from 2020, and the variable cost will be forty-two percent of sales
revenue. The fixed overhead cost will be £3,500,000, £2,000,000 and £1,500,000 in the first,
second, and third years. The promotion cost will be £500,000 in the first two years and
£200,000 for the next three years. All other expenses will be 10% of the total contribution
margin. In the second year, the company will need a working capital investment of £2 million,
and 60% of which will recover at the end of project life. The company follows a straight-line
depreciation method and expects to sell the assets at 20 % of historical cost in year 5.
Option two: Clifton Moor
On the other hand, if the showroom is opened at Clifton Moor, then it will require fixed
overhead cost for four years £2,500,000 in year one, £1,800,000 in year three, £2,100,000 in
year four and £1,100,000 in year five. All other costs will increase and be at 10% per year of the
contribution margin. The working capital investment will be £1,500,000 in year three, and 55%
of it will recover in the last year. The sales revenue will increase at 12% per annum, and variable
cost will be 45% of sales. The company will follow a similar strategy for depreciation and
promotional cost, just like the city centre.
Financing the investment
The company has several choices for financing this expansion – issuing new equity or bond or
using existing retained earnings. The shares of Daffodil are traded in the Alternative Investment
Markets (AIM) for £30, however, the face value is £20 and last year’s dividend was £0.35.
HSBC will charge a flotation cost of 10% to issue the new common stock in the market. There
is a projection that the dividend will grow at 6% a year in the coming years. The firm can issue
an additional long-term bond at an interest rate (before tax) of 10 % (i.e. Coupon rate).
Currently, similar bonds are selling at £110, slightly over the face value (which is £100), with
five years of maturity. The market risk premium is 5%, the 3-month UK gilt rate is 3.5% (riskfree rate), and the average Beta of the Electronic goods industry is 1.73.
The company is also planning to issue preferred stocks. The industry average preferred dividend
and current market price are £10 and £96, respectively. The company wants to maintain a
capital structure of approximately 45% debt, 5% preferred equity and 50% of ordinary equity.
The current corporate tax rate is 35%.
Page | 5
Required
a) Determine the Weighted Average Cost of Capital (WACC) for target capital structure.
b) Evaluate which showroom should be selected (Hints: use NPV and IRR). Ms Victoria prefers
to use CAPM (i.e., Capital Asset Pricing Model) over DDM (i.e., Dividend Discount