Company M manufactures bicycles and sells them in the wholesale market. It is considering opening up a number of retail stores which would sell complete bicycles and spare parts. This plan is subsequently referred to as Project X.Forecast financial information for Company M as at 31 December 2014:EUR million Shares (EUR 1 face value each share) 600Share premium account 200 Retained earnings 350Bank borrowings at 6% interest rate 3005% bonds 650Additional information:• The current market share price is EUR 1.50.• The bonds are quoted at a yield of 6% and a price of EUR 92 per EUR 100 of bond.• Company M has an equity beta of 1.8 and a debt beta of 0.75.• The corporate income tax rate is 25%, payable at the end of the year in which it arises. • The risk free rate is 3% and the market premium is 4%.Project X requires an initial investment of EUR 300 million on 1 January 2015 and is forecast to generate annual post tax cash flows of EUR 28 million a year. For the purposes of evaluating this project, annual cash flows should be assumed to arise at the end of the year to which they relate and assume zero growth.The project is eligible for a EUR 150 million 5 year loan from the government at a subsidized interest rate of 3%. The remaining EUR 150 million required for the initial investment would be funded by borrowings at an annual market interest rate of 5%. At the end of the 5 year loan period, the government subsidised loan can be assumed to be replaced by a bank borrowing at 5% annual interest.Company M has a long term gearing target which is very close to the debt/equity balance forecast for 31 December 2014, based on market values. Although this project is being financed using borrowings, increasing gearing, there is no intention of changing the long term gearing target. The next time that additional funding is required, the company is likely to use equity finance such as a rights issue in order to bring company gearing back in line with the long term gearing target.

Calculate, before taking Project X into account, Company M’s: • Geared cost of equity.• Ungeared cost of equity.• Weighted Average Cost of Capital (WACC).
Calculate a value for Project X using each of the following alternative approaches: • Net present value of project cash flows based on the WACC calculated in (a)above. • Adjusted present value, taking project financing into account. (
Advise the directors of Company M of the validity of each of the results obtained in part (b) above, taking all relevant factors into account.

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