Clove Ancillary Lid. owns several big boy stores h shopping ceny ou h Australia-

Question

Clove Ancillary Lid. owns several big boy stores h shopping ceny ou h Australia-Each store has two divisions: White Goods and Compute following information about Clove Ancillary Lid.: White Goods Division: Market value of net assets + $3billion, asset beta Computer Division: Market value of net assets x stores in shopping entres throughout You have the billion, asset beta = 1.8. Clove Ancillary has debt outstanding with a market value of S2billion and a ma f3%. This debt has a beta of zero market yield The most reccof dividend Clove Ancillary has 100million outstanding common shares was $7.32 per share. nsensus forecasts indicate that this level o payment should continue without growth indefinitely The risk free interest rate is 3% per annum and the required retumor, the ma is 9% per annum. Clove Ancillary faces a 30% corporate tax rate. What is the beta of Clove Ancillary shares? a. b. What is the required return on Clove Ancillary shares? (5 mark) c. What is the current share price of Clove Ancillary shares? d. What is Clove Ancillary's weighted average cost of capital? (4 mark) e. Clove Ancillary is evaluating a new store that will sell both white goods and (5 marks) mark) computers in the same proportion as current stores. It is anticipated that this new store will be financed by a combination of debt and equity such that the capitals love Ancillary will not change. The new store will cost $3,500,000 to construct and will generate free cash flows of $325,000 per year in perpetuiy, What is the NPV of this new store? (4 marks) Working for Problem 3)

Explanation / Answer

a. Now, equity beta=asset beta*{1+(1-tax rate)*debt/equity}

Given that debt market value is $2 million whose beta is zero.

Net assets of White Goods Division=$3 billion and that of Computer Division=$5 billion having asset beta of 1.2 and 1.8 respectively.

Also given corporate tax rate=30%

So equity beta of White Goods Division=1.2*{1+(1-0.3)*2/3}=1.76

Equity beta of Comnputer Division=1.8*{1+(1-0.3)*2/5}=2.304

Weighted average equity beta(taking net assets as weights)=1.76*3/8+2.304*5/8=2.1

b. Required return(according to Capital Asset Pricing Model)=risk free rate+beta*(market return-risk free return)

Given risk-free rate is 3%, market return is 9% and beta is 2.1 which was calculated in (a).

So, required return=3+2.1*(9-3)=15.6%

c. Current price=Dividend/(required return-growth)

Given recent dividend=$7.32 per share and this level of payment is expected to continue without growth.

So, current price=7.32/15.6%=$46.92

d. Weighted average cost of capital(WACC)=weight of debt*cost of debt+weight of equity*cost of equity

In the above case, we will consider market value weights since market values are given.

Given, yield of debt=3%, market value of debt=$2 billion and tax rate is 30%.

Post tax cost of debt=3(1-0.3)=2.1%

Also given there are 100 million that is 0.1 billion common shares outstanding whose cost has been calculated in (b) as 15.6% and price has been calculated in c as $46.92.

So, weight of debt=2/(2+46.92*0.1)=0.3 and of equity=0.7.

Thus, WACC=2.1*0.3+15.6*0.7=11.55%

e. Cost of proposed investment=$35,00,000 and cash flows to be generated in perpetuity=$3,25,000

Thus, FV of cash flows=3,25,000/11.55%=$28,13,853

PV of inflows=28,13,563/1.1155=$25,22,504

NPV of this investment=$(25,22,504-35,00,000)=-$9,77,496

Since NPV of the proposed investment is negative, it should not be undertaken.

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