Question

You have been hired as a financial advisor/consultant in the Financial Department of Defenders 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 overseas 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.

This land was appraised last week for $9.6 million. The company wants to build its new manufacturing plant on this land; the plant will cost $15 million to build. The following market data on DEI's securities are current:

Debt:

• 15,000 bonds outstanding

• coupon rate: 7% of face value

• 15 years to maturity

• selling for 92% of par

• the bonds have a $1,000 par value each

• make semiannual payments.

Common stock:

• 300,000 shares outstanding

• selling for $75 per share

• the beta is 1.3

Preferred stock:

• 20,000 shares outstanding

• dividend of 5 percent of current market

• selling for $72 per share

Market:

• 8% market risk premium

• 2% risk-free rate

Assume that DEI’s target debt-to-equity ratio is the same as its current actual debt-to-equity ratio. DEI uses G. M. Wharton as its lead underwriter. Wharton charges DEI spreads of 9% on new common stock issues, 7% on new preferred stock issues, and 4% on new debt issues. Wharton has included all direct and indirect issuance costs (along with its profit) in setting these spreads. Wharton has recommended to DEI that it raise the funds needed to build the plant by issuing new shares of common stock.

DEI's corporate tax rate is 35%.

The project requires $900,000 in initial net working capital investment to get operational.

The manufacturing plant has an eight-year tax life, and as a Class 43 asset, has an assigned CCA rate of 30%.

During the life of the project, the company will incur $400,000 in annual fixed costs. The plan is to manufacture 12,000 RDSs per year and sell them at $10,000 per machine. The variable production costs are $9,000 per RDS.

The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Your boss—the CFO—has told you to use an adjustment factor of +2% to account for this increased riskiness.

DEI's CFO tells you to put all your calculations, assumptions, and everything else into a report that she will present to the President. She tells you to be sure to include:

a) The appropriate discount rate to use when evaluating this project, showing how you arrived at that number.

b) The project’s initial Time 0 cash flow, considering all side effects, showing how you arrived at that number.

c) The annual Operating Cash Flows for this project, again showing how you arrived at that number.

d) The project's IRR, NPV and payback, showing how you arrived at those numbers as well.

She wants the report to include a recommendation on whether DEI should go ahead with this project and an explanation of why. She also reminds you to make any assumptions you’re making explicit

Answer 1