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.The project’s Time 0 cash flow
Cost of land	-15000000
After-tax opportunity -cost (sale value)cash loss	-5000000
Initial NWC	-825000
Total time 0 cash flows	-20825000

Cost of debt , Kd

Found with following values:

Current selling price of the bond(1000*95%)=950

Semi-annual coupon amt. in $ =1000*6.2%/2= 31

No.of semi-annual payments=25 yrs.2= 50

at a before-tax semi-annual yield= r

Using the formula to calculate PV of bond, with the above inputs,

PV of a bond=PV of its future coupons+PV of Face value to be at maturity

ie. 950=31*(1-(1+r)^-50)/r)+(1000/(1+r)^25)

Solving the above ,in an online equation solver,

we get the semi-annual before tax yield or r=

3.31%

After-tax semi-annual yield=

BTr%*(1-Tax rate)

ie. 3.30576%*(1-0.34)

2.18%

So, annual cost of debt=

(1+2.18%)^2-1=

4.41%

Cost of Equity(Common stock)

Cost of common stock,Ke=RFR+(Beta*MRP)

Ke=3.8%+(1.15*7%)

11.85%

Cost Preferred stock, Kp=

5.80%

Now calculating the

appropriate discount rate to use when evaluating DEI’s project

Type of capital	Market value	MV Weights	Cost	Wt.* Cost
Bonds(40000*950)	38000000	31.07%	4.41%	1.37%
Common stock(825000*97)	80025000	65.43%	11.85%	7.75%
Preferred stock(45000*95)	4275000	3.50%	5.80%	0.20%
Total	122300000	1		9.33%
So, WACC= 9.33%
Adding an adjustment factor of +2 percent to account for increased riskiness
appropriate discount rate to use when evaluating DEI’s project=9.33%+2%=
11.33%

3. After-tax salvage of plant
Original cost of plant	15000000
Less:Accumulated depreciation upto 5 yrs.(15000000/8*5)	9375000
Carrying value of the plant	5625000
Salvage at end of 5 yrs.	2100000
So,loss on salvage(5625000-2100000)	3525000
Tax cash out-flow saved on loss(3525000*34%)	1198500
So, after-tax salvage value of plant(2100000+1198500)	3298500

4. Annual Operating cash flows:
Sale of RDSs(12000*10800)	129600000
Less: Variable costs(12000*9900)	-118800000
Less: Fixed costs	-3500000
Less: Annual depreciation	-1875000
EBT	5425000
Less:Tax at 34% *5425000	-1844500
EAT	3580500
Add Back: Depreciation	1875000
Annual Operating cash flows	5455500

5. NPV at 11.33% discount rate
Total time 0 cash flows	-20825000
PV of annual OCF	19996699
(5455500*3.66542)
(PV A/F,5 yrs.11.33%)
PV of after-tax salvage of plant	1928666
(3298500*0.58471)
(PV F,5 th yr.11.33%)
PV of after-tax sale of land
(5300000*0.58471)	3098963
PV of NWC recovered in Yr.5	482386
(825000*0.58471)
Net Present Value at 11.33%	4681713

IRR
Rate at which, when discounting all the +ve & -ve cash flows, the NPV becomes 0
So,
0=-20825000+(5455500*(1-(1+r)^-5)/r)+(3298500/(1+r)^5)+(5300000/(1+r)^5)+(825000/(1+r)^5)
Solving the above , we get,
IRR= 18.64%