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 $5.3 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. The land was appraised last week for $6.1 million. In five years, the aftertax value of the land will be $6.5 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 $32.64 million to build. The following market data on DEI’s securities are current: Debt: 238,000 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. Common stock: 9,600,000 shares outstanding, selling for $71.80 per share; the beta is 1.3. Preferred stock: 458,000 shares of 4 percent preferred stock outstanding, selling for $81.80 per share. 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 $1,500,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally and that the NWC does not require floatation costs.. a. Calculate the project’s initial Time 0 cash flow, taking into account all side effects. (Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32.) 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. (Do not round intermediate calculations. 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 to zero. At the end of the project (that is, the end of year 5), the plant and equipment can be scrapped for $5.3 million. What is the aftertax salvage value of this plant and equipment? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32.) d. The company will incur $7,600,000 in annual fixed costs. The plan is to manufacture 21,000 RDSs per year and sell them at $11,200 per machine; the variable production costs are $9,800 per RDS. What is the annual operating cash flow (OCF) from this project? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32.) 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? (Do not round intermediate calculations and round your final answer to nearest whole number, e.g., 32.) 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. (Enter your NPV in dollars, not millions of dollars, e.g., 1,234,567. Enter your IRR as a percent. Do not round intermediate calculations and round your final answers to 2 decimal places, e.g., 32.16.)

Answer 1

a.	Calculation of project initial cash flow at Time 0
						$
	Value of Plant & Machinery					-3,26,40,000
	NWC					-15,00,000
	Issue Cost to wharton @ 7%					-24,56,774
	Total Fund required					-3,65,96,774
	Fund required				a	3,26,40,000
	Issue Cost to wharton					Fund required/ (1-Flotation cost)
	Total common stock issued				b	3,50,96,774
	Flotation cost				(b-a)	24,56,774
b.	Cost of Equity Capital					Rf+Beta*(Rm-Rf)
	Risk free return				=	4%
	Beta				=	1.3
	Market				=	6%
						6.600%
	Cost of Preference Shares					4%
	Cost of Debt					7%
	Weight of Common stock after issue of shares					$	Weight
	Outstanding Shares	9600000	Shares	@ 71.8 shares		68,92,80,000
	New Issue					3,50,96,774
						72,43,76,774	71.26%
	Prefered Stock	458000	Shares	@ 81.8 shares		3,74,64,400	3.69%
	Debt	238000	Coupon bonds	@ 1070 bond		25,46,60,000	25.05%
	Total					1,01,65,01,174	100.00%
	WACC					Ke*W+Kf*w+Kd*w*1-t)
	WACC					5.90%
	Adjustment factor					1%
	Discount factor					6.90%
c.	Cost of Plant					3,26,40,000
	Life 8 years					8	years
	Depreciation per year					40,80,000
	Depreciation for 5 year					2,04,00,000
	Salvage Value					1,22,40,000
	Tax @ 40%					-48,96,000
	Salvage Value (Net of Tax)					73,44,000
d.	Operating cash flow		Qty	Rate		$
	Revenue		21000	11200		23,52,00,000
	Variable cost		21000	9800		-20,58,00,000
	Annual Fixed cost					-76,00,000
	Operating Cash flow					2,18,00,000
e.	Break even quantity					Fixed cost /(Sales price-Variable cost)
						5429	unit
f.				Y0	Y1	Y2	Y3	Y4	Y5
	Operating cash flow			0	2,18,00,000	2,18,00,000	2,18,00,000	2,18,00,000	2,18,00,000
	Cash out flow
	Value of Plant & Machinery			-3,26,40,000
	Net working capital			-15,00,000					15,00,000
	Issue Cost to wharton @ 7%			-24,56,774
	Net Cash flow			-3,65,96,774	2,18,00,000	2,18,00,000	2,18,00,000	2,18,00,000	2,33,00,000
	Discount Factor (1/(1+r)^t	6.900%		1	0.935	0.875	0.819	0.766	0.716
	PV of Cash flow			-3,65,96,774	2,03,92,891	1,90,76,605	1,78,45,280	1,66,93,434	1,66,90,425
	NPV (sum of PV of all cash flow)			5,41,01,860
	IRR			53%
	Assumed NWC will receover at the end of Year 5 in same value