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(b) Strachan Ltd. produces electronic components for car manufacturers. It is now wondering whether to invest in new machinery which would allow it to extend its product range, in particular to supply the military, where Strachan thinks it could win some significant contracts. However, this is a higher risk area for Strachan because it involves investment in more research and more advanced technology. The following information applies to the company at the moment: Market value of debt $200m Market value of equity $900m Beta of the shares 0.8 In addition, while financing this new investment, Strachan also intends to take the opportunity to change the capital structure. The company wants to take advantage of the current low rates of interest to increase its gearing to 30 per cent of the value of its equity (in terms of relative market value). In bidding for these new contracts, Strachan is likely to be in competition with Nillson Ltd., an electronics company that concentrates very largely on meeting military contracts to supply electronic components. Nillson has an equity beta of 1.1, reflecting this company's current business activities. The risk-free rate is currently 4 per cent per annum and both companies can borrow at 2 per cent per annum above the risk-free rate. Both companies pay corporation tax at 30 per cent. The market risk premium is expected to be 6 per cent per annum.

Required

(i) Calculate Strachan's current weighted average cost of capital. (5 marks)

(ii) Under what circumstances might Strachan usefully use the weighted average cost of capital calculated in part (a) as a discount rate for future projects? (And by implication, under which circumstances should it not be used as a discount rate?) (5 marks)

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