Financial Management Assignment Questions and Answers

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Ms Nichola, the Investment Manager, has requested some analysis concerning a proposed 5- year investment. The company plans to open a showroom in Leeds and has narrowed its selection down to two locations: (1) Thorpe park and (2) Beeston. You have to evaluate these options based on the following information. Analytic will lease the showroom initially for five years, and the total initial investment cost is estimated to be £20 million each.

Option one: Thorpe Park

It is expected that the Thorpe Park showroom will increase the overall sales revenue of the company by 11% per annum from 2023, and the variable cost will be forty percent of sales revenue. The fixed overhead cost for the initial three years will be £3,500,000, £2,000,000 and £1,500,000, and zero afterwards.

The promotion cost will be £500,000 in the first two years and £200,000 for the next three years. All other operating expenses will be 10% of the total contribution margin. The company will need a working capital investment of £5 million in year two, 80% of which will recover at the end of the project’s life. The company follows a straight- line depreciation method and expects to sell the assets at 10% of historical cost in year 5.

Option two: Beeston

On the other hand, if the showroom is opened at Beeston, then it will require fixed overhead costs for four years £2,500,000 in year one, £2,800,000 in year three, £2,100,000 in year four and £2,100,000 in year five. All other operating costs will be 10% per year of the contribution margin. The working capital investment will be £5,500,000 in year three, and 75% will recover in the last year. The sales revenue will increase by 12% per annum, and variable cost will be 47%. The company will follow a similar depreciation and promotional cost strategy as the Thorpe Park showroom.

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 Analytic are traded in the Alternative Investment Markets (AIM) for £3.5. However, the face value is £1.0, and last year’s dividend was £0.35. HSBC will charge a flotation cost of 9% to issue the new common share in the market. There is a projection that the dividend will grow 5% yearly in the coming years. In addition, the firm can issue an additional long-term bond at an interest rate (before tax) of 8% (i.e., Coupon rate). Similar bonds are selling at £105 in the market, slightly over the face value (£100), with five years of maturity. The market risk premium is 6%, the 3-month UK gilt rate is 4.5% (risk-free rate), and the average Beta of the Electronic goods industry is 1.53.

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 40% debt, 10% preferred equity and 50% ordinary shares. The current corporate tax rate is 35%.

Required

1. Determine the Weighted Average Cost of Capital (WACC) for the target capital structure.
   1. Evaluate the showrooms and comment on which one should be selected (Hints: use NPV and IRR). Ms Nichola prefers to use CAPM (i.e., Capital Asset Pricing Model) over DDM (i.e., Dividend Discount Model).
   2. Advise accordingly with appropriate assumptions and rationales for the future.

[Following profit statement is provided for your reference to calculate the net cash benefit by your investment manager Ms Nichola]

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