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 $7.3 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 $7.77 million after taxes. In five years, the land will be worth $8.07 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.68 million to build. The following market data on DEI’s securities are current:

Debt: 93,400 7 percent coupon bonds outstanding, 24 years to maturity, selling for 93.3 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock: 1,820,000 shares outstanding, selling for $95.70 per share; the beta is 1.12.

Preferred stock: 86,000 shares of 6.3 percent preferred stock outstanding, selling for $93.70 per share.

Market: 7.05 percent expected market risk premium; 4.95 percent risk-free rate.

DEI’s tax rate is 22 percent. The project requires $910,000 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.)

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 +2 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.)

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 $1.67 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.)

d. The company will incur $2,470,000 in annual fixed costs. The plan is to manufacture 14,700 RDSs per year and sell them at $12,100 per machine; the variable production costs are $11,300 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.)

e. Calculate the project's net present value. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89)

f. 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.)

Answer 1

Answers:
Reading from NPV table
a. Time-0 cash flows:
1.After-tax sale proceeds of land	7770000
2. After-tax sale proceeds of land lost
3.Cost to build- plant	-13680000
4.NWC reqd. & recovered	-910000
Total time 0 cash flows	-6820000

b. Calculation of WACC- the appropriate discount rate

After-tax cost of bonds, kd

using the formula to find the present value,ie.current market Price of bonds,

Price/PV =PV of its future cash flows=PV of all its future coupon cash flows+PV of face value to be received at maturity----both discounted at the Yield or YTM--which is the before-tax cost of the bond

ie. Price /PV =(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n)

where, price is given as 1000*93.3%= $ 933

Pmt.= The semi-annual   coupon in $ , ie. 1000*7%/2= $ 35

r= the   semi-annual Yield or YTM /before-tax semi-annual cost of the bond--- to be found out---??

n= no.of coupon period still to maturity, ie. 24 yrs.*2= 48

FV= face value, ie. $ 1000

So, plugging in these values in the formula,

ie.933=(35*(1-(1+r)^-48)/r)+(1000/(1+r)^48)

Solving the above for r, we get the before-tax semi-annual cost of the bond as

3.80592%

So, the annual before-tax cost=

(1+3.80592%)^2-1=

7.75669%

now the after-tax annual cost of the bond, kd==

Before tax cost*(1-Tax rate)

ie. 7.75669%*(1-22%)=

6.05%

Cost of common stock, ke

as per CAPM,ke=RFR+(Beta*Market risk premium)

ie. 4.95%+(1.12*7.05%)=

12.85%

Cost of preferred stock, kps

k ps= $ dividend/Current market price

ie. (100*6.3%)/93.70=

6.72%

Now, calculating the WACC for discounting DEI's cash flows:

Type of capital	Market Values	Wt. to Total	Cost	Wt.*Cost
Bonds	93400*933=	87142200	32.35%	6.05%	1.96%
Common stock	1820000*95.70=	174174000	64.66%	12.85%	8.31%
Pref. stock	86000*93.70=	8058200	2.99%	6.72%	0.20%
Total		269374400	100.00%	WACC=	10.47%
				AdjFactor	2%
				Adj. WACC=	12.47%

c. Aftertax salvage value of this manufacturing plant
Cost to build the plant	13680000
Acc. Depn.(13680000/8*5)	-8550000
Book value	5130000
Scrap value	1670000
Loss on salvage(BV-SV)	3460000
Cash outflow saved for tax on loss at 22%*loss	761200
ATCF on salvage(SV+ Tax saved)	2431200

d.Operating cash flows:
6.Sales revenues(14700*12100)	177870000
7.Variable costs(14700*11300)	-166110000
8. Fixed costs	-2470000
9. Depreciation(13680000/8)	-1710000
10. EBIT(Sum 6 to 9)	7580000
11. Tax at 22%(10*22%)	-1667600
12. NOPAT(10+11)	5912400
13. Add back: Depn. (row 9)	1710000
14.Operating cash flows(12+13)	7622400

e & f.NPV analysis
a.Project’s Time 0 cash flow
Year	0	1	2	3	4	5
1.After-tax sale proceeds of land	7770000
2. After-tax sale proceeds of land lost						-8070000
3.Cost to build- plant	-13680000
4.NWC reqd. & recovered	-910000					910000
5. ATCF on salvage(Ref. wkgs.in c.)						2431200
Operating cash flows:
6.Sales revenues(14700*12100)		177870000	177870000	177870000	177870000	177870000
7.Variable costs(14700*11300)		-166110000	-166110000	-166110000	-166110000	-166110000
8. Fixed costs		-2470000	-2470000	-2470000	-2470000	-2470000
9. Depreciation(13680000/8)		-1710000	-1710000	-1710000	-1710000	-1710000
10. EBIT(Sum 6 to 9)		7580000	7580000	7580000	7580000	7580000
11. Tax at 22%(10*22%)		-1667600	-1667600	-1667600	-1667600	-1667600
12. NOPAT(10+11)		5912400	5912400	5912400	5912400	5912400
13. Add back: Depn. (row 9)		1710000	1710000	1710000	1710000	1710000
14.Operating cash flows(12+13)		7622400	7622400	7622400	7622400	7622400
15. FCFs(1+2+3+4+5+14)	-6820000	7622400	7622400	7622400	7622400	2893600
16. PV f at 12.47%(1/1.1247^yr.n)	1	0.88913	0.79055	0.70289	0.62496	0.55567
17. PV F at 12.47%(15*16)	-6820000	6777273.94	6025850.395	5357740.19	4763706	1607885.1
18. NPV at 12.47%(sum of row 17)	17712455.71	Ans. E
19.IRR(of row 15)	106.86%	Ans. F