In: Finance
Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.
A negative answer should be indicated by a minus sign.
Problem: Project Evaluation
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 $3.5 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. The land
was appraised last week for $4.3 million. In five years, the
after-tax value of the land will be $6.4 million, but the company
expects to keep the land for a future project. The company wants to
build its new manufacturing plant on this land; the plant and
equipment will cost $30.93 million to build. The following market
data on DEI’s securities is current:
Debt: |
220,000 7 percent coupon bonds outstanding, 25 years to maturity, selling for 107 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Clarification: Number of bonds outstanding = 220,000 |
Common stock: |
7,800,000 shares outstanding, selling for $70.00 per share; the beta is 1.3. |
Preferred stock: |
440,000 shares of 4 percent preferred stock outstanding, selling for $80.00 per share and and having a par value of $100. |
Market: |
6 percent expected market risk premium; 4 percent risk-free rate. |
DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI
spreads of 7 percent on new common stock issues, 5 percent on new
preferred stock issues, and 3 percent 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 tax rate is 40 percent. The project
requires $1,050,000 in initial net working capital investment to
get operational. Assume Wharton raises all equity for new projects
externally.
a. Calculate the project’s initial Time 0 cash
flow, taking into account all side effects. Assume that the net
working capital will not require flotation costs.
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 +1 percent to account for this increased riskiness.
Calculate the appropriate discount rate to use when evaluating
DEI’s project.
c. The manufacturing plant has an eight-year tax
life, and DEI uses straight-line depreciation. At the end of the
project (that is, the end of Year 5), the plant and equipment can
be scrapped for $3.5 million. What is the after-tax salvage value
of this plant and equipment?
d. The company will incur $5,800,000 in annual
fixed costs. The plan is to manufacture 12,000 RDSs per year and
sell them at $10,300 per machine; the variable production costs are
$8,900 per RDS. What is the annual operating cash flow (OCF) from
this project?
e. DEI’s comptroller is primarily interested in
the impact of DEI’s investments on the bottom line of reported
accounting statements. What will you tell her is the accounting
break-even quantity of RDSs sold for this project?
f. Finally, DEI’s president wants you to throw all
your calculations, assumptions, and everything else into the 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. Assume that the net working capital will not require
flotation costs.