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 $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. If the land were sold today, the net proceeds would be $7.67 million after taxes. In five years, the land will be worth $7.97 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.28 million to build. The following market data on DEI’s securities are current:

Debt:		45,700 7 percent coupon bonds outstanding, 22 years to maturity, selling for 94.3 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock:		757,000 shares outstanding, selling for $94.70 per share; the beta is 1.27.
Preferred stock:		35,700 shares of 6.3 percent preferred stock outstanding, selling for $92.70 per share.
Market:		7.1 percent expected market risk premium; 5.3 percent risk-free rate.

DEI’s tax rate is 30 percent. The project requires $860,000 in initial net working capital investment to get operational.

a.
Calculate the project’s Time 0 cash flow, taking into account all side effects. Assume that any NWC raised does not require floatation costs. (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, e.g., 1,234,567.)

Time 0 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 and 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 (i.e., the end of Year 5), the plant can be scrapped for $1.57 million. What is the aftertax salvage value of this manufacturing plant? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)

Aftertax salvage value            $

d.
The company will incur $2,370,000 in annual fixed costs. The plan is to manufacture 13,700 RDSs per year and sell them at $11,100 per machine; the variable production costs are $10,300 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, e.g., 1,234,567.)

Operating cash flow            $

e.
Calculate the project's net present value. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Net present value            $

Calculate the project's internal rate of return. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Internal rate of return

Answer 1

(i)	Initial cash flow =
	Opportunity cost of land			7670000
	Plant			13280000
	Initial NWC			860000
				21810000
(ii)	Calculation of WACC -
a	Cost of Debt =		YTM of BOND
	YTM is the rate at which price of bond if discounted is = PV cashflows of bond
	Coupon =	1000 x 7% x 1/2 =		35
	No. of payments =	22 x 2		44
	Selling price =	1000 x 94.3% =		943
	943	=	35 x PVAF(YTM,44) + 1000 x PVIF(YTM,44)
	YTM			Price
	4%			897.25579
	YTM			943
	3.5%			1000
	Using linear Interpolation -
	YTM-3.5/4-3.5 =		943-1000/897.2558-1000
	YTM-3.5 =		0.554776
	YTM =		4.054776	Semi annual
	Post tax cost of debt =		4.054776 x 2 x (1-30%)		5.676686
b.	Cost of equity
	Re =	Rf + (Rm-Rf) x Beta
		5.3+ 7.1x1.27
		14.317
c.	Cost of preferred stock		6.3/92.7	6.7961165
	WACC -
	Source	Market value=NO. x Price	Cost of capital(%)	W x C
		(w)	(c )
	Debt	43095100	5.676686	2446373.6
	Equity	71687900	14.317	10263557
	Preferred stock	3309390	6.796117	224910
		118092390		12934840
	WACC =	12934840/118092390 x 100		10.95%
	Discount rate for project =	10.95+3		13.95%
(iii)	Salvage value of land(Post tax) =
	Post tax salvage value of plant =
	Sale price (t=5)			1570000
	Carriying value	cost x (8-5)/8 =		4980000
	Loss on sale			-3410000
	Tax savings			-1023000
	Post tax salvage value of plant =			2593000
(iv)	Annual Operating Cash flows =
	Sales	13700 x 11100		152070000
	Variable cost	13900 x 10300		143170000
	Fixed cost			2370000
	Depreciation	cost/8 =		1660000
	PBT			4870000
	Less: Tax 30%			1461000
	Add: Depreciation			1660000
	OCF			3121000
(v)	NPV =
	Year	Cashflow	PV factor @ Discount rate	PV of cashflows
	0	-21810000	1	-21810000
	1	3121000	0.877554	2738844.8
	2	3121000	0.7701	2403483.1
	3	3121000	0.675804	2109185.3
	4	3121000	0.593055	1850923.1
	5	6574000	0.520437	3421353.6
				-9286210
	IRR =	-3.882% or 0
		=IRR(Cashflows Array)