Orange, Inc. is currently a market leader in biomedical test equipment, but the firm’s future has never been more uncertain, as it is contemplating two projects that fall into the “unchartered waters” category. The CEO, Tim Jobless, who also owns 50.1% of the firm’s 1 million outstanding shares, often disagrees with the rest of the shareholders. The first project under evaluation is production of the ePhone, a smartphone that is more smart than phone. Its marketing department has engaged Ripoff Consults Ltd, a marketing research firm, that estimates ePhone annual unit sales to be 20,000 at the planned price point of $500 per phone over the next ten years, after which fickle consumers are likely to move on to the next big thing. Orange Inc’s operations managers estimate variable costs to be $200 per phone, and annual fixed costs to be $1 million. Initial investment in fixed assets and net working capital are $2.5 million and $500,000 respectively. The fixed assets are expected to be worthless by the end of the project and the net working capital investment non-recoverable. Tim Jobless’ pet project under consideration, however, is his self-proclaimed revolutionary eSlate, which is basically four ePhones in a sleek exterior—minus the phone. As a gesture of goodwill, Ripoff Consults Ltd estimates at “no additional charge” the annual unit sales of the eSlate to be 8,000 units at the target price of $600 per unit over the next five years. Variable costs are expected to be $300 per unit, and annual fixed costs $500,000. Net capital spending and changes in net working capital for this tablet project are exactly the same as those for the ePhone project, and fixed assets will be depreciated on a straight-line basis to zero book value over the respective projects’ lives. Despite having completed its end of the deal, Ripoff Consults Ltd allows Orange, Inc. to delay for five years’ payment of their consulting fee of $800,000. Undertaking the eSlate project will result in a 20 percent reduction of ePhone sales (i.e., some prospective customers of the ePhone are likely to use the smartphone as everything but a phone) whereas undertaking the ePhone project will not result in cannibalization of eSlate sales. Should both projects be undertaken, this will result in annual fixed cost economies of $300,000. Orange, Inc. is currently an all-equity firm but plans to raise debt in the near future to achieve their desired debt-equity ratio of 1.0. Orange, Inc.’s beta is 2.0, while unlevered Cherry, Inc., a likely competitor that specializes only in smartphones and tablets has a beta of 1.5. The expected market portfolio return is 13%, and the risk-free return is 5%. The marginal corporate tax rate is 30%. Assume that Orange, Inc. can borrow at the risk-free return and that financial distress is costless. For the coming year, the annual dividend by Orange, Inc. will be 20% of the yearly CFFA attributable to the project(s), if undertaken. Tim Jobless is planning to increase the dividend payout to 30% for the coming year, but dissenting shareholders are satisfied with the current dividend policy and propose that Time Jobless relies on “homemade dividends” instead. Analysts expect Orange, Inc.’s target stock price to be $20 in a year.
(a) Calculate and justify discount rates for the ePhone and eSlate projects.
(b) What is the optimal investment decision for Orange, Inc.?