Question

Case: Please show your calculations and formulas used.

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. If the company sold the land today, it would receive $5.1 million after taxes. In five years, the land can be sold for $6.0 million after taxes, but DEI intends 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 $35 million to build. The following market data on DEI's securities are current:

Debt:     240,000 7.5 percent coupon bonds outstanding, 20 years to maturity, selling for 94 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock: 9,000,000 shares outstanding, selling for $71 per share; the estimated beta is 1.2.

Preferred stock: 400,000 shares of 5.5 percent preferred stock outstanding, par value of $100 per share, selling for $81 per share.

Market: 8 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 equity (stock) issues, 6 percent on new preferred stock issues and 4 percent on new debt (bond) issues. Wharton has included all direct and indirect costs (along with its profit) in setting these spreads. In estimating DEI’s WACC, you should assume that DEI retains their existing capital structure weights for debt, common stock and preferred stock in order to finance the project. DEI's tax rate is 35 percent. The project requires $1,300,000 in initial net working capital (NWC) investment to get operational. Assume Wharton raises all financing for the new project, to include the amount needed for NWC, externally.

Questions:

1 - The manufacturing plant and equipment has an eight-year tax life, and DEI uses straight-line depreciation. At the end of the project (i.e., the end of Year 5), the plant and equipment can be sold for $6 million. Do not confuse the market value of the plant and equipment with the market value of the land. What is the after-tax salvage value of the equipment?

2 - The company will incur $7,000,000 in annual fixed costs. The plan is to manufacture 18,000 RDSs per year and sell them at $10,900 per machine; the variable production costs are $9,400 per RDS. What is the annual operating cash flow, OCF, from this project?

3 - 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 are both the Accounting and Financial Break-Even quantity of RDSs sold for this project? For an understanding of Accounting and Financial Break-Even (Break-Even Point), “the break-even approach determines the sales needed to break even on the project investment – the point where the project generates no profits or loss.”

4 - What will be your estimate of NPV and IRR if the average RDS sales price per unit must be reduced by 5 percent (from $10,900 per unit to $10,355 per unit) in order to sell the 18,000 proposed units that are being manufactured? Will you still recommend the project?

Answer 1

The $4 million cost of the land 3 years ago is a sunk cost and irrelevant; the $6

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

relevant market value capitalization weights are:

       MV_D = 240,000($1,000)(0.94) = $225,600,000

       MV_E = 9,000,000($71) = $639,000,000

       MV_P = 400,000($81) = $3,240,000

The total market value of the company is:

      

       V = $225,600,000 + 639,000,000 + 3,240,000 = $897,000,000

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 = .05 + 1.2(.08) = .1460 or 14.60%

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

       P₀ = $940 = $37.5(PVIFA_R%,40) + $1,000(PVIF_R%,40)

       R = 4.06%

       YTM = 4.06% × 2 = 8.11%

And the aftertax cost of debt is:      

       R_D = (1 – .35)(.0811) = .0527 or 5.27%

       The cost of preferred stock is:

       R_P = $5.5/$81 = .0679 or 6.79%

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 = –$6,000,000 – 35,000,000 – 1,300,000 = –$42,300,000

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

               WACC = [($639/$897)(.1460) + ($3.24/$897)(.0679) + ($225.6/$897)(.0527)] = .1197

       The annual depreciation for the equipment will be:

               $35,000,000/8 = $4,375,000

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

               BV₅ = $35,000,000 – 5($4,375,000) = $13,125,000

       a.     So, the aftertax salvage value will be:

              

               Aftertax salvage value = $6,000,000 + .35($13,125,000 – 6,000,000) = $8,493,750

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

              

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

               OCF = [($10,900 – 9,400)(18,000) – 7,000,000](1 – .35) + .35($35M/8) = $17,375,000

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

                 Q_A = (FC + D)/(P – v) = ($7,000,000 + 4,375,000)/($10,900 – 9,400) = 7,583 units

d. 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        –$42,300,000

                           1            17,375,000

                           2           17,375,000

                           3           17,375,000

                           4           17,375,000

                           5             33,168,750

               Using the required return of 11.97 percent, the NPV of the project is:

              

               NPV = –$42,300,000 + $17,375,000(PVIFA_11.97%,4) + $33,168,750/1.1197⁵

               NPV = $29,353,372.96

               And the IRR is:

               NPV = 0 = –$42,300,000 + $17,375,000(PVIFA_IRR%,4) + $33,168,750/(1 + IRR)⁵

               IRR = 34.75%