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

a)	Initial Cash outlay= Sale proceeds from old land+ Prchase of new investment + working capitalTax on Sale
		=	($5Mn- $4.5Mn)+ $15Mn+ 825,000- 0.5Mn(1-0.34)
			$15.985Mn
b)	Cost of Debt		Using calucaltor
			N=25, PV= -38000 , FV =40000, PMT 40000*6.2%= 2480
			I/Y= 6.614
			Cost =6.614(1-0.34)=4.49%
	Cost of Eqity		As per CAPM Modal
			Risk free return+ Beta(Risk Premium)
			3.8+ 1.15(7)
			11.85%
	Cost of pref. Stock		5.80%
	WACC=	Weight of Debt/Equity/Pref Stock* Cost
	Total Capital				Weight
		Debt	40000*95	38,00,000.00	0.043133
		Equity	825000*97	800,25,000.00	0.908343
		Pref Stock	45000*95	42,75,000.00	0.048524
				881,00,000.00
	COST=	COST OFDEBT*WEIGHT OF DEBT+ COST OF EQUITY* WEIGHT OF EQUITY+ COST OF PREF * WEIGHT OF PREF
		4.49%*0.043133+ 11.85%*0.908343+ 5.8%*0.048524
		0.112389709
		11.24%
	ADD 2%	13.24%
C)	Cost of Land =$15Mn
	Depf for 5 Years= 15*5/8
		9.375
	Cost after 5 Years		$15Mn-$9.375mN
			$5.625
	Sale after 5 years		$2.1
	So, salvage value= $2.1Mn+ Tax advantage 0.34(5.625-2.1)
			$3.2985
d)	Operating cash flow
		Sales	$10800*12000	1296,00,000.00
	Less	Variable cost	$9900*12000	1188,00,000.00
		Contribution		108,00,000.00
	Less	Fixed Cost		35,00,000.00
		EBIT		73,00,000.00
	Less	Int	4000000*6.2%	2,48,000.00
	Less	Dep	$15Mn/8	18,75,000.00
		Profit before tax		51,77,000.00
	Less	Tax(34%)		17,60,180.00
		Profit after Tax		34,16,820.00
	Add	Dep		18,75,000.00
		Cash flow		52,91,820.00