XYZ Energy Solutions plc (XYZ) has spent €12m designing and developing a new generation of domestic air source heat pumps. These new domestic heat pumps can easily be fitted to existing wet heating systems and will reduce household heating bills significantly. This is XYZ's first venture into the domestic market. It will continue to manufacture its larger commercial models of air and ground source heat pumps. This new generation of air source heat pumps is expected to have a production life of 4 years. The finance director is busy arranging a new debt facility for XYZ and has asked you to prepare an investment appraisal report to present to the next board meeting, which will make a recommendation to the directors on whether to proceed with the project.

XYZ already owns a vacant site adjacent to their existing factory worth €4m. The new factory would be built on this site. Initial investment in plant and equipment would be €90m. XYZ charges depreciation on a straight line basis over the useful life of assets. The residual value of the plant and equipment at the end of the project is expected to be €10m. The annual depreciation charge would therefore be €20m. The project will also require additional working capital of €8m for the life of the project. It is expected that only 75% of the working capital investment will be recovered at the end of the project.

Currently, net investment in plant and equipment is eligible for capital allowances on a straight line basis over 4 years. The applicable corporate tax rate is 28%. Capital allowances are paid in the same year that they are claimed. However, taxes on profits and gains on assets qualifying for capital allowances are paid one year in arrears.

XYZ expects to sell 13,000 pumps in the first year at a unit price of €4,000, with this level of sales and the sales price staying the same in future years. XYZ will incur additional annual administration costs of €3m. Each year other total annual operating costs will be €12m.
It is the current government's policy to encourage the use of energy efficient devices. The government is proposing that consumers installing energy efficient devices in their homes will be eligible for grant aid.

XYZ's shares are currently listed on the London stock exchange, where they currently trade at £2.50 ( =...Euro)with an equity beta of 1.6. The expected equity risk premium is 10% and risk-free rate is 4%. XYZ currently has a market debt to equity ratio (D/(D+E)) of 25%. XYZ has sufficient resources available to fund this new project from current facilities. The current average before tax cost of borrowing for the company is 6%. Currently inflation is 2.5% per annum and is likely to remain so over the life of the project.

Required

(a) Calculate the weighted average cost of capital (WACC) for XYZ. [(6 marks)]

(b) Carry out a discounted cash flow analysis of the project based on the information given and calculate the net present value (NPV) of the project.

Give the Finance Director a clear decision whether you think he should recommend XYZ to proceed with the project. Briefly explain the reasoning behind your decision.

Also mention any reasons for excluding any of the information given above and explain any additional assumptions you have made while making your calculations.

(c) XYZ is in the process of negotiating a new debt facility. This will provide XYZ with additional funds for a whole new series of projects and product upgrades. The new capital structure will result in XYZ's market debt to equity ratio (D/(D+E)) increasing to 50%. As a consequence of the increased gearing, the before tax cost of debt will increase to 8%. The increased gearing will also change the equity market's perception of risk at XYZ. Calculate the new WACC for XYZ. Recalculate your NPV for the project.

Does this change your previous recommendation? Explain your reasoning behind any change you may wish to make to your previous recommendation.