Question

Problem 14-30 Project Evaluation [LO3, 4]

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 $3.7 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 $6.7 million on an aftertax basis. In five years, the aftertax value of the land will be $7.2 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 $33.4 million to build. The following market data on DEI’s securities are current:

Debt:	285,000 bonds with a coupon rate of 6.8 percent outstanding, 26 years to maturity, selling for 108 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock:	10,300,000 shares outstanding, selling for $75.50 per share; the beta is 1.2.
Preferred stock:	505,000 shares of 4.6 percent preferred stock outstanding, selling for $85.00 per share. The par value is $100.
Market:	6.8 percent expected market risk premium; 3.7 percent risk-free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 6.5 percent on new common stock issues, 4 percent on new preferred stock issues, and 2 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 25 percent. The project requires $1,675,000 in initial net working capital investment to get operational. Assume DEI raises all equity for new projects externally and that the NWC does not require floatation costs..

a.	Calculate the project’s initial Time 0 cash flow, taking into account all side effects. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole dollar amount, e.g., 1,234,567.)
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 +3.0 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c.	The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation to a zero salvage value. At the end of the project (that is, the end of Year 5), the plant and equipment can be scrapped for $6.0 million. What is the aftertax salvage value of this plant and equipment? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole dollar amount, e.g., 1,234,567.)
d.	The company will incur $8,300,000 in annual fixed costs. The plan is to manufacture 19,750 RDSs per year and sell them at $11,150 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 and enter your answer in dollars, not millions of dollars, rounded to the nearest whole dollar amount, e.g., 1,234,567.)
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 nearest whole number, e.g., 32.)
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. (Do not round intermediate calculations. Enter your NPV in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89. Enter your IRR as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

a) Calculate the project’s initial Time 0 cash flow, taking into account all side effects. (A negative answer should be indicated by a minus sign)
Initial Cash Flow
Cost of Land	-$6,700,000.00
Cost of Plant (calculated below)	-$35,223,662.50
Net Working Capital	-$1,675,000.00
Cash flow at Time 0	-$43,598,662
weighted Floatation Cost
	Market Value (calculated below)	Weights	Floatation Cost	Weighted flotation cost
Debt	$307,800,000.00	27.28%	2.00%	0.55%
Common Stock	$777,650,000.00	68.92%	6.50%	4.48%
Preferred Stock	$42,925,000.00	3.80%	4.00%	0.15%
Total	$1,128,375,000.00	100.00%		5.18%
Amount raised for cost of Plant = Amount raised (1- 5.18%) = 33,4000,000	$35,223,662.50
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 +3.0 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project.
First Compute WACC
	Market Value	Weights	Cost	WACC
Debt	$307,800,000.00	27.28%	4.63%	1.26%
Common Stock	$777,650,000.00	68.92%	11.86%	8.17%
Preferred Stock	$42,925,000.00	3.80%	5.41%	0.21%
Total	$1,128,375,000.00	100.00%		9.64%
WACC	9.64%
Adjustment factor	3.00%
Discount rate	12.64%
Debt
Face Value	$                        1,000.00
Coupon Payment = 1000 x 6.8%/2	$                             34.00
Nper = 26 x 2	52
Present Value  = $1000 x 108%	1080
Semi Annual Cost of Debt = YTM = Rate	3.09%
Annual Cost of Debt  after tax =2 x 3.09% x (1-25%)	4.63%
Market Value = 285,000 x $1080	$             307,800,000.00
Common Stock
Cost  of Equity = Risk free rate + Beta x Market Risk Premium = 3.7% + 1.2 x 6.8%	11.86%
Market Value = 10300000 shares x $75.50	$             777,650,000.00
Preferred Stock
Cost of Preferred = Dividend/ Price = $100 x 4.6% / $85	5.41%
Market Value = 505,000 shares x $85	$               42,925,000.00
c) The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation to a zero salvage value. At the end of the project (that is, the end of Year 5), the plant and equipment can be scrapped for $6.0 million. What is the aftertax salvage value of this plant and equipment?
Annual depreciation for the equipment = $33400000 /8	$                 4,175,000.00
Book value = $33400000 - (5 x 4,175,000)	$               12,525,000.00
Aftertax salvage value = $6,000,000 + (25% x (12,525,000 - 6,000,000)	$                 7,631,250.00
d.    The company will incur $8,300,000 in annual fixed costs. The plan is to manufacture 19,750 RDSs per year and sell them at $11,150 per machine; the variable production costs are $9,900 per RDS. What is the annual operating cash flow (OCF) from this project? :
OCF = [(P – v)Q – FC](1 – t) + tCD
OCF = [($11,150 – 9,900)(19,750) – 8,300,000](1 – .25) + .25($33.4M/8)	$               13,334,375.00
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?
e. Accounting breakeven = QA = (FC + D)/(P – v) = ($8,300,000 + 4,175,000)/($11150 – 9,900)	9,980.00	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 @12.64%	Present Value
0	$              (43,598,662.50)	1.0000	$            (43,598,662.50)
1	$               13,334,375.00	0.8878	$             11,837,686.79
2	$               13,334,375.00	0.7881	$             10,508,991.12
3	$               13,334,375.00	0.6997	$               9,329,432.04
4	$               13,334,375.00	0.6211	$               8,282,270.02
5	$               29,840,625.00	0.5514	$             16,454,277.46
NPV			$             12,813,994.93
IRR	22.66%
Cashflow in 5th year = OCF + NWC + Residual value + aftertax value of the land
a) Time 0 cash Flow	$              (43,598,662.50)
b) Discount Rate	12.64%
c) After tax salvage value	$                 7,631,250.00
d) Operating Cash Flow	$               13,334,375.00
e) BEP	$                        9,980.00
f)
IRR	22.66%
NPV	$               12,813,994.93