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 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 $4.8 million. In five years, the aftertax value of the land will be $5.2 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 $31.6 million to build. The following market data on DEI’s securities is current:

Debt: 225,000 7.2 percent coupon bonds outstanding, 25 years to maturity, selling for 108 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 $70.50 per share; the beta is 1.1.

Preferred stock: 445,000 shares of 5 percent preferred stock outstanding, selling for $80.50 per share and and having a par value of $100.

Market: 7 percent expected market risk premium; 5 percent risk-free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 8 percent on new common stock issues, 6 percent on new preferred stock issues, and 4 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 35 percent. The project requires $1,175,000 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 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 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 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 $6,300,000 in annual fixed costs. The plan is to manufacture 14,500 RDSs per year and sell them at $10,550 per machine; the variable production costs are $9,150 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:

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

a. Year 0 cash flows
Investment in plant and equipment	31.6
Initial net working capital	1.175
Year 0 cash flows	32.775
	millions
ie.	32775000

b.

Cost of debt

(108%*1000)-(4%*1080)=((7.2%/2*1000)*(1-(1+r)^-50)/r)+(1000/(1+r)^50)

Solving for r , we get the semi-annual r as

3.445%

Annual r= (1+3.445%)^2-1= 7.01%

After-tax cost of debt=7.01%*(1-35%)=

4.56%

Cost of preferred stock

Dividends /(Current Market Price*(1-6%))

5/(80.50*(1-6%))=

6.61%

Cost of new equity

as per CAPM

Ke=RFR+Beta*(Market Return-RFR)

Ke=5%+(1.1*7%)

12.7%

WACC
Type of capital	Weights		Cost	Wt. Cost
Debt	243000000	29.74%	4.56%	1.36%
New equity(70.5*(1-8%))	538338000	65.88%	12.70%	8.37%
Preferred stock	35822500	4.38%	6.61%	0.29%
	817160500	1		10.01%
WACC=	10.01%
So, discount rate taking into account the adjustment factor
10.01%+2%=
12.01%

c. Carrying value of P& E at end of Year 5
31600000/8*3=	11850000
Salvage	4000000
Loss on salvage	7850000
Tax savings on loss 7850000*35%	2747500
So, after-tax salvage (4000000+2747500)	6747500
After-tax salvage value $	6747500

d.
Sale value (14500*10550)	152975000
Less: Variable costs(14500*9150)	-132675000
Less: Fixed costs	-6300000
Less: st.line Depreciation(31600000/8)	-3950000
EBT	10050000
Tax at 35%	-3517500
EAT	6532500
Add Back Depn.	3950000
Operating cash flow $	10482500

e.

Accounting break-even quantity of RDSs sold for this project=

(Fixed costs+Depreciation)/(Contribution per RDS

ie.( 6300000+3950000)/(10550-9150)=

7321

f. NPV of the project
Initial Year 0 Cah flows	-32775000
After-tax salvage value 6747500/1.1201^5	3827004
PV of annual Operating cash flows(10482500*3.60338)(PVOA F 12.01%, 5 yrs.)	37772431
Recovery of working capital(1175000/1.1201^5)	666429
Net Present value of the investment	9490864
IRR:    Equating the cash flows to 0
-32775000+(6747500/(1+r)^5)+(10482500*(1-(1+r)^-5)/r)+(1175000/(1+r)^5)=0
& solving for r, we get ,the IRR as
22.23%