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 $6 million in anticipation of using it as a toxic dumps site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $4.25 million. The company wants to build its new manufacturing plant on this land; the plant will cost $7.2 million to build. The following market data on DEI’s securities are current:

Debt:                           10,000 8% coupon bonds outstanding, 15 years to maturity selling for 94% of par; the bonds have a $1,000 par value each and make semiannual payments.

Common Stock:           250,000 shares outstanding, selling for $65 per share; the beta is 1.3.

Preferred stock:           10,000 shares of 7% preferred stock outstanding, selling for $81 per share.

Market:                       8% expected market risk premium; 5.65% risk-free rate

DEI’s tax rate is 34%. The project requires $750,000 in initial net working capital investment to get operational.

Calculate the project’s Time 0 cash flow, taking into account all side effects.

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 adjusted factor of +2% to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project.

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 $2 million. What is the after-tax salvage value of this manufacturing plant?

The company will incur $900,000 in annual fixed costs. The plan is to manufacture 10,000 RDSs per year and sell them at $10,000 per machine; the variable production costs are $9,100 per RDS. What is the annual operating cash flow, OCF, from this project?

Finally, DEI’s president wants you to throw all your calculations, all your assumptions, and everything else into a 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. What will you report?

Answer 1

Initial Cost= Cost of the land + Cost of plant + Initial working Capital,

Cost of the land = last appraised value will be considered and this is the opportunity Cost of using land , because otherwise the company can sell and receive money of appraised value.

=$4.25million + $7.2million + $750,000 = $12.2million,

Discount rate for the project = WACC + Risk premium,

WACC = (Kd after tax X D / (E+P+D)) + ((Ke X E) / (E+P+D)) + ((Kp X P) /  (E+P+D))

kd = YTm,

For finding YTM, using Near approximation method,

Under Near Approximation method =

YTM = Interest or coupon +((Maturity value - Current Value) / life) / ((Maturity value - Current Value)/2)

= (80+((1000-940)/ 15)) / ((1000-940)/ 2)

=0.0948453608247423 or 9.48453608247423%,

Ke applying CAPM = Rf + Beta ( Rm-Rf),

Rf = 5.65%,

Beta = 1.3, Rm-Rf = market risk premium = 8%,

CAPM = 5.65% + (1.3 X 8%) = 16.05%,

KP = No information about maturity of preference, so it is assumed that Preference is perpetual, Kp = Preference divident / market price = 7/81 = 0.0864197530864197, or 8.64197530864197%,

After tax Kd = Before tax Kd X (1-Tax rate),

Tax Rate = 34% or 0.34,

So kd After tax = 9.48453608247423% X (1-0.34),

6.25979381443299%,

E is value of Equity = 250,000 shares X $65 = $16,250,000,

P =Value of Preferred Stock = 10,000 shares of 7% preferred stock X $81 = $810,000,

D is the value of Debt = 10,000 8% coupon bonds X 940 = $9,400,000,

E+P+D =  $16,250,000 + $810,000 + $9,400,000,

=$26,460,000,

WACC = ((6.25979381443299% X $9,400,000) / $26,460,000) + ((16.05% X $16,250,000) / $26,460,000) + ((8.64197530864197% X $810,000) /  $26,460,000)

=2.22381186151437% + 9.85685941043084% + 0.264550264550264%,

WACC = 12.3452215364955%, ,

Discount Rate for this project = 12.3452215364955% 2% = 14.3452215364955%, rounded to 2 decimal places = 12.35%,

The manufacturing plant has an eight-year tax life, and DEI uses straight line depreciation.
Depreciation   = Cost of Asset / life = $7.2million / 8 years,   =							900000
Annual Cash flow
manufacture 10,000 RDSs
Sales prices =$10,000 per RDSs
Sales			100000000
Variable Cost			91000000
Fixed cost			900000
Profit Before Depreciation			8100000
Depreciation			900000
Profit Before Tax			7200000
Tax@ 34%			2448000
Profit After Tax			4752000
Add depreciation			900000
Annual Cash flow After Tax			5652000
Salvage Value = $2000000
Book value =Cost of Asset - Depreciation for the 5 years
Book value =		27000000
Loss on sale of Asse = 2,700,000 - 2,000,000					700000
Assumes that the company is allowed to adjust this loss
then it's tax savings = 700,000 X 34%,				238000
So salvage value after tax = 2,000,000 + 238,000 = 2,238,000
year	Cash flow		Discount Factor		Present Value
Year 1-5	5652000		3.5741590756884		20201147.0957907000000
Year5	2238000		0.558762144		1250509.6783604300000
		Total PV of cash inflow			21,451,656.7741511000000
		Year0 Cash outflow			12,200,000.0000000000000
			NPV		9,251,656.7741510800000

LR = 40%
year	Cash flow		Discount Factor		Present Value
Year 1-5	5652000		2.0351639197953		11502746.4746832000000
Year5	2238000		0.558762144		1250509.6783604300000
		Total PV of cash inflow			12753256.1530436000000
		Year0 Cash outflow			12200000.0000000000000
			NPV@LR		553256.1530435920000
HR = 45%
year	Cash flow		Discount Factor		Present Value
Year 1-5	5652000		1.8755273046868		10600480.3260900000000
Year5	2238000		0.558762144		1250509.6783604300000
		Total PV of cash inflow			11850990.0044504000000
		Year0 Cash outflow			12200000.0000000000000
			NPV@HR		-349009.9955496020000

IRR = LR + ((NPV@LR / (NPV@LR /NPV@HR) (HR -LR)

40 + 553256.1530435920000 /(553256.1530435920000- -349009.9955496020000) (45-40),

=(40+ 3.06592546947608 ) %

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