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 $4.4 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 $5.2 million. In five years, the aftertax value of the land will be $5.6 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 $31.92 million to build. The following market data on DEI’s securities is current:

Debt:	229,000 7 percent coupon bonds outstanding, 25 years to maturity, selling for 107 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock:	8,700,000 shares outstanding, selling for $70.90 per share; the beta is 1.3.
Preferred stock:	449,000 shares of 4 percent preferred stock outstanding, selling for $80.90 per share and and having a par value of $100.
Market:	6 percent expected market risk premium; 4 percent risk-free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 7 percent on new common stock issues, 5 percent on new preferred stock issues, and 3 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 40 percent. The project requires $1,275,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally.

a.

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

Cash flow

$

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

Discount rate

%

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 $4.4 million. What is the aftertax salvage value of this plant and equipment? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)

Aftertax salvage value

$

d.

The company will incur $6,700,000 in annual fixed costs. The plan is to manufacture 16,500 RDSs per year and sell them at $10,750 per machine; the variable production costs are $9,350 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

$

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 final answer to the nearest whole number.)

Break-even quantity

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. Assume that the net working capital will not require flotation costs. (Enter your NPV answer in dollars, not millions of dollars (e.g., 1,234,567). Enter your IRR answer as a percent. Do not round intermediate calculations and round your final answers to 2 decimal places (e.g., 32.16).)

IRR	%
NPV	$

Answer 1

The $4.4 million cost of the land 3 years ago is a sunk cost and irrelevant; the $5.2

million appraised value of the land is an opportunity cost and is relevant. The

relevant market value capitalization weights are:

       MV_D = 229,000($1,000)(1.07) = $245,030,000

       MV_E = 8,700,000($70.90) = $616,830,000

       MV_P =449,000($80.90) = $36,324,100

       The total market value of the company is:

      

       V = $245,030,000 + 616,830,000 + 36,324,100 = $898,184,100

       Next we need to find the cost of funds. We have the information available to calculate the cost of equity using the CAPM, so:

       R_E = .04 + 1.3(.06) = .1180 or 11.8%

  The cost of debt is the YTM of the company’s outstanding bonds, so:

       P₀ = $1070 = $35(PVIFA_R%,50) + $1,000(PVIF_R%,50)

       R = 3.22%

       YTM = 3.22% × 2 = 6.44%

       And the aftertax cost of debt is:          

       R_D = (1 – .40)(.0644) = .0386 or 3.86%

       The cost of preferred stock is:

       R_P = $4/$80.90 = .0494 or 4.94%

       a.     The initial cost to the company will be the opportunity cost of the land, the cost of the plant, and the net working capital cash flow, so:

               CF₀ = –$5,200,000 – 31,920,000 – 1,275,000 = –$85,195,000

b.    To find the required return on this project, we first need to calculate the WACC for the company. The company’s WACC is:

               WACC = [($616.83/$898.1841)(.1180) + ($36.3241/$898.1841)(.0494) + ($245.03/$898.1841)(.0386)] = .0936

               The company wants to use the subjective approach to this project because it is located overseas. The adjustment factor is 1 percent, so the required return on this project is:

               Project required return = .0936 + .01 = .1036

       c.     The annual depreciation for the equipment will be:

               $31,920,000/8 = $3,990,000

               So, the book value of the equipment at the end of five years will be:

               BV₅ = $31,920,000 – 5($3,990,000) = $11,970,000

               So, the aftertax salvage value will be:

              

               Aftertax salvage value = $4,400,000 + .40(11,970,000 – 4,400,000) = $7,428,000

       d.     Using the tax shield approach, the OCF for this project is:

              

               OCF = [(P – v)Q – FC](1 – t) + t_CD

               OCF = [($10,750 – 9,350)(16,500) – 6,700,000](1 – .40) + .40($31.92M/8) = $11,436,000

e.     The accounting breakeven sales figure for this project is:

                 Q_A = (FC + D)/(P – v) = ($6,700,000 + 3,990,000)/($10,750 – 9,350) = 7,636 units

f.     We have calculated all cash flows of the project. We just need to make sure that in Year 5 we add back the aftertax salvage value, the recovery of the initial NWC, and the aftertax value of the land. The cash flows for the project are:

                         Year          Flow Cash               

                           0        –$85,195,000

                           1            11,436,000

                           2           11,436,000

                           3           11,436,000

                           4           11,436,000

                           5             25,739,000

               Using the required return of 10.36 percent, the NPV of the project is:

              

               NPV = –$85,195,000 + $11,436,000(PVIFA_10.36%,4) + $25,739,000/1.1036⁵

               NPV = -$33,502,202.47

               And the IRR is:

               NPV = 0 = –$85,195,000 + $11,436,000(PVIFA_IRR%,4) + $25,739,000/(1 + IRR)⁵

               IRR = 4.95%