A company operating within the electronic components sector is Yarrow plc, the management are currently considering two exciting potential new projects. If either one of the projects is undertaken, it would likely change the current risk environment. One senior member of the management team considers it preferable to seek projects that would maintain the companys current risk profile. The business operates two distinct divisions: Components and Services.

The Components Division supplies highly specialised consumables, with an expertise recognised in the market. The Services Division involves the customised design, commissioning, installation and servicing of systems to a wide range of users within the entertainment industry. This division is a recent addition to the operations via merger activity; it is still working on consolidating the forecast synergies. The directors of Yarrow plc have been looking to invest in new projects.

They are considering whether to undertake one of the following two projects: Project 1 is forecast to offer a return of 18% net of tax and has a beta coefficient of 1.4. Project 2 is forecast to offer a return of 14% net of tax and has a beta coefficient of 1.1. Both Projects require the same initial outlay of 15m. The returns on the projects will be received in perpetuity. The directors are looking to finance the project by issuing new risk free debentures. Yarrow plc is currently all equity financed with a market value of 50m. Yarrow plc has a beta coefficient of 1.6.

Assume that the capital market is in equilibrium, and that the expected rate of return on the market portfolio is 14% and the return on a risk-free security is 6%. Assume that the corporation tax rate is 25%.

(a) (i) Advise the Directors which of the two projects Yarrow plc should accept? Fully explain your answer.

(ii) Calculate the new value of the Yarrow plc Company once the better project, based on your advice in part (i), has been accepted. State any assumptions that you make.

(iii) Calculate the existing return to the shareholders of Yarrow plc before the project is accepted and Calculate the new return to the shareholders once the better project has been accepted. Explain why there is a difference between the two.