Question

This is a comprehensive project evaluation problem bringing together much of what you have learned in this and previous chapters. 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 $3.9 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 $4.4 million on an after-tax basis. In five years, the after-tax value of the land will be $4.8 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 $37 million to build. The following market data on DEI’s securities are current:

Debt: 210,000 6.4 percent coupon bonds outstanding, 25 years to maturity, selling for 110 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock: 8,300,000 shares outstanding, selling for $68 per share; the beta is 1.3.

Preferred stock:450,000 shares of 4.5 percent preferred stock outstanding, selling for $79 per share.

Market: 6 percent expected market risk premium; 3.5 percent risk-free rate.

DEI uses HSOB as its lead underwriter. Wharton charges DEI spreads of 10 percent on new common stock issues, 6 percent on new preferred stock issues, and 4 percent on new debt issues. HSOB has included all direct and indirect issuance costs (along with its profit) in setting these spreads. HSOB 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 32 percent. The project requires $1,300,000 in initial net working capital investment to get operational. Assume DEI raises all equity for new projects externally.

Calculate the project’s initial Time 0 cash flow, taking into account all side effects.

(This includes an adjustment for the flotation costs described in the above paragraph.The total costs will be the opportunity cost of the land, the cost of the building and the cost of the working capital.The cost of the building and working capital will require new financing and therefore finance costs.Thus the building and working capital must be adjusted for the flotation costs as discussed in section 14-7 of the 11^th edition and 14-6 of the 10^th edition of the text.It is not necessary to adjust the land costs since we already own the land.)

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.

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 $5.1 million. What is the after-tax salvage value of this plant and equipment?

The company will incur $6,700,000 in annual fixed costs. The plan is to manufacture 15,300 RDSs per year and sell them at $11,450 per machine; the variable production costs are $9,500 per RDS. What is the annual operating cash flow (OCF) from this project? Remember in year 5 that besides the cash flows from operation, you also get the salvage, tax benefit, land and the working capital back. Note that while the WC outlay includes the financing costs, the amount back in time 5 will only be the WC amount. So the outlay for WC is 1,300,000 plus financing costs, but you only recover the $1,300,000 since the financing costs have been paid out to your underwriter.

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. What will you report?

Answer 1

a)
Initial Cash Flow
Cost of Land	-$4,400,000
Cost of Plant (calculated below)	-$40,287,851.33
Net Working Capital	-$1,300,000
Cash flow at Time 0	-$45,987,851.33
weighted Floatation Cost
	Market Value (calculated below)	Weights	Floatation Cost	Weighted flotation cost
Debt	$231,000,000	27.80%	4.00%	1.11%
Common Stock	$564,400,000	67.92%	10.00%	6.79%
Preferred Stock	$35,550,000	4.28%	6.00%	0.26%
Total	$830,950,000	100.00%		8.16%
Amount raised for cost of Plant = Amount raised (1-8.16%) = 37,000,000	$40,287,851.33
b. The new XYZ project is somewhat riskier than a typical project for ASE primarily because the plant is being located overseas. Management has told you to use an adjustment factor of 1 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating AESI’s project.
First Compute WACC
	Market Value	Weights	Cost	WACC
Debt	$231,000,000	27.80%	3.84%	1.07%
Common Stock	$564,400,000	67.92%	11.30%	7.68%
Preferred Stock	$35,550,000	4.28%	5.70%	0.24%
Total	$830,950,000	100.00%		8.99%
WACC	8.99%
Adjustment factor	2.00%
Discount rate	10.99%
Debt
Face Value	$1,000
Coupon Payment = 1000 x 6.4%/2	$32
Nper = 25 x 2	50
Present Value = $1000 x 110%	1100
Semi Annual Cost of Debt = YTM = Rate	2.82%
Annual Cost of Debt after tax =2 x 2.82% x (1-32%)	3.84%
Market Value = 210,000 x $1100	$231,000,000
Common Stock
Cost of Equity = Risk free rate + Beta x Market Risk Premium = 3.5% + 1.3 x 6%	11.30%
Market Value = 8300000 shares x $68	$564,400,000
Preferred Stock
Cost of Preferred = Dividend/ Price = $100 x 4.5% / $79	5.70%
Market Value = 450,000 shares x $79	$35,550,000
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 $5.1 million. What is the after-tax salvage value of this plant and equipment?
Annual depreciation for the equipment = $37000000 /8	$4,625,000
Book value = $37000000 - (5 x 4,625,000)	$13,875,000
Aftertax salvage value = $5,100,000 + (32% x (13,875,000 - 5,100,000)	$7,908,000
d.The company will incur $6,700,000 in annual fixed costs. The plan is to manufacture 15,300 RDSs per year and sell them at $11,450 per machine; the variable production costs are $9,500 per RDS. What is the annual operating cash flow (OCF) from this project? What is the annual operating cash flow (OCF) from this project? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
OCF = [(P – v)Q – FC](1 – t) + tCD
OCF = [($11,450 – 9,500)(15,300) – 6,700,000](1 – .32) + .32($37M/8)	$17,211,800
e.ASE’s comptroller is primarily interested in the impact of ASE’s investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of XYZs sold for this project?
e. Accounting breakeven = QA = (FC + D)/(P – v) = ($6,700,000 + 4,625,000)/($11,450 – 9,500)	$5,807.69	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.
Year	Cashflow	PV @10.99%	Present Value
0	-$45,987,851.33	1.0000	-$45,987,851.33
1	$17,211,800	0.9010	$15,507,988.04
2	$17,211,800	0.8118	$13,972,838.01
3	$17,211,800	0.7315	$12,589,653.89
4	$17,211,800	0.6590	$11,343,392.44
5	$31,219,800	0.5938	$18,538,557.97
NPV			$25,964,579.01
IRR	29.69%
Cashflow in 5th year = OCF + NWC + Residual value + aftertax value of the land