Question

Project Evaluation. This is a comprehensive project evaluation problem bringing together much of what you have learned in this and previous chapters. 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 $4.5 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 $5 million after taxes. In five years, the land will be worth $5.3 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $19.5 million to build. The following market data on DEI’s securities are current:

Debt:

Common stock: Preferred stock: Market:

60,000 6.2 percent coupon bonds outstanding,
25 years to maturity, selling for 95 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
1,250,000 shares outstanding, selling for $97 per share; the beta is 1.15.
90,000 shares of 5.8 percent preferred stock outstanding, selling for $95 per share.
7 percent expected market risk premium; 3.8 percent risk-free rate.

DEI’s tax rate is 34 percent. The project requires $825,000 in initial net working capital investment to get operational.

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

2. 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.

3. 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 $2.1 million. What is the aftertax salvage value of this manufacturing plant?

4. The company will incur $3,500,000 in annual fixed costs. The plan is to manufacture 13,000 RDSs per year and sell them at $10,800 per machine; the variable production costs are $9,900 per RDS. What is the annual operating cash flow, OCF, from this project?

5. 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?  

Can you explain the solution step by step?

Answer 1

SOLUTION: