Goodway plc is a holding company owning shares in various subsidiary companies. Its directors are currently considering several projects which will increase the range of the business activities undertaken by Goodway plc and its subsidiaries. The directors would like to use discounted cash flow techniques in their evaluation of these projects but as yet no weighted average cost of capital (WACC) has been calculated.

Lord Harris Tweed, the Managing Director, has called a meeting of the directors to discuss the calculation and use of the weighted average cost of capital as the discount rate for future capital investment decisions.

Shilpa Gohal, the Finance Manager, has been asked to draw up some relevant figures for the calculation of the company's weighted average cost of capital, as shown below.

Goodway plc has an authorised share capital of 10 million 25p ordinary shares, of which 8 million have been issued. The current ex div market price per ordinary share is £1.10, a dividend of 11.4p per share having been paid recently. The company's project analyst has calculated that 12% is the most appropriate after-tax cost of equity capital.

Extracts from the latest balance sheets for the group are given below:

All debt interest is payable annually and all the current year's payments will be made shortly. The current cum interest market prices for £100 nominal value stock are £31.60 and £103.26 for the 3% and 9% loan stock respectively. Both the 9% loan stock and the 6% unsecured loan stock are redeemable at par in ten years' time.

The 6% stock is not traded on the open market, but the analyst estimates that its effective current ex-interest market price for £100 nominal stock is £75.42. The bank loans bear a nominal interest at 13% and are repayable in six years. The effective corporation tax rate of Goodway plc is 35%.

Lord Harris Tweed remarks that once the WACC had been calculated, it should be used to calculate all the proposed capital investment projects that were about to be undertaken. They had always used one discount rate in the past, and the economic climate was favourable and unlikely to change in the future.

Esther Banda, the Production Director, also agrees stating that one discount rate would give uniformity to their decision-making process. However, Shilpa Gohal is not so sure, as, "not all of the proposed investments have the same risk profile, and discount rates based on the cost of their individual financing, might be more appropriate," (i.e. those projects financed by a specific source of debt, for instance, should be discounted at the cost of the particular source).

Mark Darcy, Shilpa's assistant, points out that some of the proposed projects are outside the organisation's usual activities and that, therefore, any WACC based on figures related to their current activities may be inappropriate. He says, "When I was at university I remember calculating a risk-based discount rate based on the Capital Asset Pricing Model."

Once he has attracted attention Mark also decides to demonstrate how intelligent he is and says, "I also remember that whatever WACC we use it would be better to have a lower one as this will make future projects more attractive. I know that the cost of debt is supposed to be cheaper than the cost of equity. Therefore, I think we should restructure and issue more debt and attempt to lower our WACC."

Required:

Task 1

Calculate the effective Weighted Average Cost of Capital (WACC) from the information given in the scenario, as initially required by the directors.

Task 2

Provide a consideration of Shilpa Gohal's opinion with regard to the calculation of a suitable cost of capital.

Task 3

Mark Darcy has introduced the possibility of using the Capital Asset Pricing Model (CAPM) in order to calculate a suitable cost of capital for projects.

a) Provide a full rationale as to the use of CAPM for the calculation of a risk-adjusted specific discount rate.

b) One particular capital project available to Goodway would involve an expansion into an unfamiliar industry, at the time when the above financial data was gathered.

At this time it was estimated that the appropriate risk free rate of return in the economy was 5% and that the return on the market is assumed to be 14%.

Should the investment take place Goodway does not anticipate that its gearing will change from that indicated in the scenario. Corporate debt is assumed to have a beta of 0.20 (i.e. it is not risk free) and the company's equity beta is estimated at 0.78.

At the time, a typical surrogate company in the same industry, Noggin plc, has the following Balance Sheet.

£m

Non-current assets 3.00

Net current assets 2.01

5.01

Financed by:

Long Term debt 2.60

Ordinary shares (£1 par value/share) 0.60

Reserves 1.81 5.01

The share price for Noggin plc at the Balance Sheet date is £3.51 and the equity beta of the company is 1.51. Noggin has the same effective rate of taxation as Goodway plc.

Required:

You should estimate a risk-adjusted Weighted Average Cost of Capital (using CAPM) which Goodway can use in the proposed diversification into the unfamiliar industry.

Task 4

Provide a critical analysis that considers Mark Darcy's comments concerning the possibility of issuing more debt in order to lower the Weighted Average Cost of Capital.

You should provide a well-researched response indicating whether or not you agree with his suggestion.

Task 5

Instead of undertaking 'organic' growth as indicated in Task 3 (b) Goodwaycould expand into the unfamiliar industry by acquisition.

You are required to provide a critical analysis of the relative benefits of the two types of growth (i.e. 'organic' and acquisition) from Goodway's point of view.