Question

Suppose you have been hired as a financial consultant to Defense Electronics, Inc. (DEI), a large, publicly traded firm that is the market share leader in radar detection systems (RDSs). The company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs. This will be a five-year project. The company bought some land three years ago for $4.8 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $5.6 million. In five years, the aftertax value of the land will be $6 million, but the company expects to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost $32.24 million to build. The following market data on DEI’s securities is current:

Debt:	233,000 7.2 percent coupon bonds outstanding, 25 years to maturity, selling for 108 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock:	9,100,000 shares outstanding, selling for $71.30 per share; the beta is 1.1.
Preferred stock:	453,000 shares of 5 percent preferred stock outstanding, selling for $81.30 per share and and having a par value of $100.
Market:	7 percent expected market risk premium; 5 percent risk-free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 8 percent on new common stock issues, 6 percent on new preferred stock issues, and 4 percent on new debt issues. Wharton has included all direct and indirect issuance costs (along with its profit) in setting these spreads. Wharton has recommended to DEI that it raise the funds needed to build the plant by issuing new shares of common stock. DEI’s tax rate is 35 percent. The project requires $1,375,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally.

a. Calculate the project’s initial Time 0 cash flow, taking into account all side effects. Assume that the net working capital will not require flotation costs. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)

Cash flow           $

b. The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Discount rate            %

c. The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation. At the end of the project (that is, the end of Year 5), the plant and equipment can be scrapped for $4.8 million. What is the aftertax salvage value of this plant and equipment? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)

Aftertax salvage value           $

d. The company will incur $7,100,000 in annual fixed costs. The plan is to manufacture 18,500 RDSs per year and sell them at $10,950 per machine; the variable production costs are $9,550 per RDS. What is the annual operating cash flow (OCF) from this project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)

Operating cash flow           $

e. DEI’s comptroller is primarily interested in the impact of DEI’s investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of RDSs sold for this project? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

Break-even quantity            units

f. Finally, DEI’s president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the RDS project’s internal rate of return (IRR) and net present value (NPV) are. Assume that the net working capital will not require flotation costs. (Enter your NPV answer in dollars, not millions of dollars, e.g., 1,234,567. Enter your IRR answer as a percent. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

IRR	%
NPV	$

Answer 1

a]

Time 0 cash out flow = cost of plant and equipment + investment in net working capital

Time 0 cash outflow = $32,240,000 + $1,375,000 = $33,615,000

Time 0 cash flow = -$33,615,000

The cost of the land, its appraised value and its after-tax value are are irrelevant since it is not an incremental cash flow for this project. It is a cost already incurred for other purposes, and cannot be recovered. It is a sunk cost

b]

Discount rate to use = WACC + adjustment factor

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity)

market value of debt = bonds outstanding * price per bond = 233,000 * $1,000 * 108% = $251,640,000

market value of preferred stock = shares outstanding * price per share = 453,000 * $81.30 = $36,828,900

market value of equity = shares outstanding * price per share = 9,100,000 * $71.30 = $648,830,000

total market value = $251,640,000 + $36,828,900 + $648,830,000 = $937,298,900

weight of debt = $251,640,000 / $937,298,900 = 0.268

weight of preferred stock = $36,828,900 / $937,298,900 = 0.039

weight of equity = $648,830,000 / $937,298,900 = 0.692

cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 25*2 (25 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 7.2% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -1000 * 108% (current bond price = face value * 108%. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

the RATE is calculated to be 3.27%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 6.55%

cost of debt = YTM * (1 - tax rate)

cost of debt = 6.55% * (1 - 35%) ==> 4.25%

cost of preferred stock = dividend / current price = ($100 * 5%) / $81.30 = 6.15%

cost of equity (CAPM) = risk free rate + (beta * market risk premium)

cost of equity (CAPM) = 5% + (1.1 * 7%) ==> 12.70%

WACC = (0.268 * 4.25%) + (0.039 * 6.15%) + (0.692 * 12.70%) = 10.18%

Discount rate to use = 10.18% + 2% = 12.18%

c]

Annual depreciation = cost of plant / tax life = $32,240,000 / 8 = $4,030,000

Total depreciation for 5 years = 5 * $4,030,000 = $20,150,000

Book value of plant at end of 5 years = $32,240,000 - $20,150,000 = $12,090,000

Before tax salvage value = $4,800,000

Loss on sale = sale price - book value = $4,800,000 - $12,090,000 = $7,290,000

Tax benefit on loss = ($7,290,000 * 35%) = $2,551,500

After tax salvage value = Before tax salvage value + Tax benefit on loss = $4,800,000 + $2,551,500 = $7,351,500

d]

Annual OCF = net income + annual depreciation

net income = (sales - variable costs - fixed costs - annual depreciation) * (1 - tax rate)

net income = [(18,500 * $10,950) - (18,500 * $9,550) - $7,100,000 - $4,030,000] * (1 - 35%) = $9,600,500

Annual OCF =  $9,600,500 + $4,030,000 = $13,630,500