Orange Technology Solutions is considering expansion of its existing operation by assessing three different projects. Project I has an expected return of 15.9 per cent, project II carries a potential return of 14.4 per cent while project III is expected to earn 28.1 per cent return per annum. To evaluate these investment alternatives, the manager will compare the cost of these projects against their respective expected returns. The following information will apply to all three projects:
a. The company’s outstanding debentures were sold at a face value of $100 with a yearly coupon rate of 10 per cent. Any new issue would require a yield of 14 per cent with a maturity of seven years. The outstanding debentures will mature in seven years.
b. The preference shares are traded at $0.80, which is well below their $2 par value. Dividend is 5% of its par value.
c. The beta of the company is approximately 1.2 and the last traded price of the ordinary share was $1.00. The after-tax market risk premium is 10 per cent and government securities are currently trading at a rate of 13.5 per cent.
d. The following information is also available from the company’s balance sheet:
Preference shares (5% dividend, $2 par value) $500,000
Ordinary share paid-up capital ($1 par value) $2,000,000
Calculate the company’s after-tax weighted-average cost of capital (WACC) and determine which of the three projects the company should accept. The relevant tax rate is 30%.