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 $4.5 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. If the land were sold today, the net proceeds would be $5 million after taxes. In five years, the land will be worth $5.3 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $15 million to build. The following market data on DEI’s securities are current:

Debt:	40,000 6.2 percent coupon bonds outstanding, 25 years to maturity, selling for 95 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock:	825,000 shares outstanding, selling for $97 per share; the beta is 1.15.
Preferred stock:	45,000 shares of 5.8 percent preferred stock outstanding, selling for $95 per share.
Market:	7 percent expected market risk premium; 3.8 percent risk-free rate.

DEI’s tax rate is 34 percent. The project requires $825,000 in initial net working capital investment to get operational.

Requirement 1:

Calculate the project’s Time 0 cash flow, taking into account all side effects. Assume that any NWC raised does not require floatation costs. (Do not round intermediate calculations. Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)

Initial time 0 cash flow

$

Requirement 2:

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 percentage rounded to 2 decimal places (e.g., 32.16).)

Discount rate

%

Requirement 3:

The manufacturing plant has an eight-year tax life, and DEI uses straightline depreciation. At the end of the project (i.e., the end of year 5), the plant can be scrapped for $2.1 million. What is the aftertax salvage value of this manufacturing plant? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)

Aftertax salvage value

$

Requirement 4:

The company will incur $3,500,000 in annual fixed costs. The plan is to manufacture 12,000 RDSs per year and sell them at $10,800 per machine; the variable production costs are $9,900 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

$

Requirement 5:
(a)	Calculate the net present value. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)

Net present value

$

(b)	Calculate the internal rate of return. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

Internal rate of return %

Answer 1

1-	cost of machine		15000000
	investment in working capital		825000
	initial cash outlay		15825000
2-	cost of debt	using rate function in ms excel	rate(nper,pmt,pv,fv,type)	3.31%
	Annual after tax rate	(3.31*2)*(1-.34)	4.3692
	cost of preferred stock	preferred dividend/market price	5.8/95	6.11%
	cost of equity	risk free rate+(market risk premium )*beta	3.8+(7)*1.15	11.85
	WACC on market value weights
	source	value	weight	cost	weight*cost
	debt	38000000	0.310711365	4.37	1.35780867
	preferred	4275000	0.034955029	6.11	0.21357522
	equity	80025000	0.654333606	11.85	7.75385323
		122300000	WACC	sum of weight*cost	9.33
	WACC for project	9.33+2	11.33%
	3-	book value of machine after 5 years	15000000*(1-accumulated depreciation rate)	15000000*(1-.625)	5625000
		scrap value of machine			2100000
		loss on sale of machine	5625000-2100000		3525000
		tax benefit on loss on sale of machinesale of		3525000*34%	1198500
		after tax salvage value	2100000+1198500		3298500
	year	0	1	2	3	4	5
	initial investment	-15825000
	sales		129600000	129600000	129600000	129600000	129600000
	less variable cost		118800000	118800000	118800000	118800000	118800000
	less fixed cost		3500000	3500000	3500000	3500000	3500000
	less depreciation		1875000	1875000	1875000	1875000	1875000
	operating profit		5425000	5425000	5425000	5425000	5425000
	after tax profit = operating profit*(1- 34%)		3580500	3580500	3580500	3580500	3580500
	net operatin after profit = after tax profit+ depreciation		5455500	5455500	5455500	5455500	5455500
	recovery of working capital						825000
	after tax scrap value						3298500
	net operating cash flow	-15825000	5455500	5455500	5455500	5455500	9579000
	present value of cash flow = net operating cash flow/(1+r)^n r= 11.33%	-15825000	4900296.416	4401595.631	3953647.38	3551286.61	5600916.9
	NPV = sum of present value of cash flow	6582742.9
	IRR = using irr function in MS excel =irr(-15825000,5455500,5455500,5455500,54555500,9579000)	25.56%