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 $4.2 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 million. In five years, the aftertax value of the land will be $5.4 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 $31.76 million to build. The following market data on DEI’s securities is current: Debt: 227,000 7.4 percent coupon bonds outstanding, 25 years to maturity, selling for 109 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Common stock: 8,500,000 shares outstanding, selling for $70.70 per share; the beta is 1.2. Preferred stock: 447,000 shares of 6 percent preferred stock outstanding, selling for $80.70 per share and and having a par value of $100. Market: 8 percent expected market risk premium; 6 percent risk-free rate. DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 9 percent on new common stock issues, 7 percent on new preferred stock issues, and 5 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 38 percent. The project requires $1,225,000 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 3 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 $4.2 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 $6,500,000 in annual fixed costs. The plan is to manufacture 15,500 RDSs per year and sell them at $10,650 per machine; the variable production costs are $9,250 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

Kindly have a look at the below table for the solution

Kindly note the following assumptions

• Land shall have no opportunity cost for the project since the company did not plan to sell it even if the project did no go through.
• The entire working capital shall be released at the end of the project.
• The company shall get a tax benefit at the end for the sale of the plant since the sale value is lower than its book value. The same is added to the scrap value to get the after tax salvage value.

The relevant cost of capital for the project shall be the cost of new equity adjusted for increased riskiness. The same is calculated below:

K_e = R_f + (R_m-R_f)*

Where,

K_e is the cost of equity

R_f is the risk free rate

R_m-R_f is the market risk premium

is the beta of the company.

In the above problem,

K_e = 6% + (8%*1.2) = 15.6%

Since the project has increased the risk, we add another 3% as per management estimates and also adjust for the floatation costs of 9%.

Cost of capital for the project = (15.6%+3%)/0.91 = 20.44%

Kindly also have a look at the following table for the NPV of the project:

Note that IRR is 23.84% (to the 2 decimal places)

Accounting break-even (in units) is given by = Annual Fixed costs/ Contribution per unit

Contribution per unit = Sales price per unit – Variable costs per unit

=10650-9250 = 1400

Annual Fixed costs = Operating fixed costs + Depreciation on basis of useful life of 5 years

       = 6500000 + (317,60,000/5) = 12852000

Hence, break-even quantity = 12852000/1400 = 9180 units per annum.