Question

You have been hired as a financial consultant to Defense Electronics, Inc (DEI). The company is looking to set up a manufacturing plant overseas to produce a new product line. This will be a five-year project. The plant will be built on land already owned by DEI. That land could be sold today for $5.3 million. If the company pursues the project, the value of the land is projected to be $5.7 million in five years. The plant will cost $32 million to build and the project will require an initial net working capital investment of $1.3 million. This $32 million will be depreciated straight-line to zero over the five years of the project, but will be able to be scrapped for $3 million. The plant is expected to generate pre-tax “sales minus costs” each year of $12 million.   The tax rate is 35%. Find WACC and use as the discount rate to find the NPV. You have the following information regarding the firms’ sources of financing:

-There are 230,000 7.2% coupon bonds outstanding with 25 years to maturity and a YTM of 6.8%.

-There are 8.8 million shares outstanding, selling for $71 per share. The beta is 1.1

-The market risk premium is 7% and the risk-free rate is 5%.

Answer 1

Price of the bond =PV(rate,nper,pmt,fv) =PV(0.068/2,25*2,27/2,1000) = 1047.77

Bond Value = 230000*1047.77 = 240,987,100

Equity Value = 8,800,000*71 = 624,800,000

Total = 865,787,100

Weight of debt = 240,987,100/865,787,100 = 0.2783

Weight of equity = 1-0.2783 = 0.7217

Cost of Equity = Rf + beta* MRP = 5 + 1.1*7 = 12.7%

After tax cost of debt = 6.8*(1-0.35) = 4.42%

WACC = 0.2783*4.42 + 0.7217*4.42 = 10.40%

WACC = 10.40%

The NPV is calculated as shown below:

Year	0	1	2	3	4	5
Cost	-32000000
Initial WC	-1300000
Savings		12000000	12000000	12000000	12000000	12000000
Depreciation		-6400000	-6400000	-6400000	-6400000	-6400000
Profit before taxes		5600000	5600000	5600000	5600000	5600000
Taxes		-1960000	-1960000	-1960000	-1960000	-1960000
Net profit after tax		3640000	3640000	3640000	3640000	3640000
Add back depreciation		6400000	6400000	6400000	6400000	6400000
Return of Wac						1300000
Land Profit after tax						260000
After tax salavge value						1950000
Net Cash flow	-33300000	10040000	10040000	10040000	10040000	13550000
NPV at 10.40%	$ 6,513,988.26

Note:

1. Capital gain from land after tax = (5,700,000 -5,300,000)*(1-0.35) =$ 260,000

2. After tax salavge value = 3,000,000*(1-0.35) = $1,950,000