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 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 $7.74 million after taxes. In five years, the land will be worth $8.04 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.56 million to build. The following market data on DEI’s securities are current:

Debt:		46,400 7.2 percent coupon bonds outstanding, 18 years to maturity, selling for 93.6 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock:		764,000 shares outstanding, selling for $95.40 per share; the beta is 1.15.
Preferred stock:		36,400 shares of 6.4 percent preferred stock outstanding, selling for $93.40 per share.
Market:		7.2 percent expected market risk premium; 5.4 percent risk-free rate.

DEI’s tax rate is 40 percent. The project requires $895,000 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.)

Time 0 cash flow            $

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 and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Discount rate             %

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 $1.64 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.)

Aftertax salvage value            $

d.
The company will incur $2,440,000 in annual fixed costs. The plan is to manufacture 14,400 RDSs per year and sell them at $11,800 per machine; the variable production costs are $11,000 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.)

Operating cash flow            $

e.
Calculate the project's net present value. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Net present value            $

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.)

Internal rate of return             %

Answer 1

	a	INITIAL INVESTMENTS			(Time 0 cash Flow)
		Land (Opportunity cost)	$7.74	million
		Cost of Plant	$13.56	million
		Initial working capital	$0.895	million
		Total	$22.195	million
		Time 0 CashFlow	$22,195,000
	b	Discount Rate:
		Debt:
		Par Value	$1,000
	Pmt	Annual Coupon payment=(7.2%*1000)	$72
	Nper	Number of years	18
	Pv	Present market value per Bond	$936
	Fv	Payment at maturity	$1,000.00
	RATE	Yield to maturity	7.88%	(Using RATE function of excel with Nper=18,, Pmt=72,Pv=-936, Fv=1000)
		Excel Command:RATE(18,72,-936,1000)
		Before tax cost of debt	7.88%
	Cd	After Tax Cost of debt=7.88*(1-0.4)	4.73%
	Md	Market Value of Debt(46400*936)	$43,430,400
	Me	Market Value of Equity(764000*$95.4)	$72,885,600
	Mp	Market Value of Preferred(36400*93.4)	$3,508,960
	Mt	Total Capital at Market Value	$119,824,960
	Wd=Md/Mt	Weight of Debt	0.36
	We=Me/Mt	Weight of Equity	0.61
	Wp=Mp/Mt	Weight of Preferred Stock	0.03
		Cost of Equity=Risk Free rate +Beta*MarketRisk Premium
	Ce	Cost of Equity=5.4%+1.15*7.2%=	13.68%
	Cp	Cost of Preferred=6.4/0.934=	6.85%
	WACC=Wd*Cd+We*Ce+Wp*Cp	Weighted Average Cost of Capital	10.23%	(4.73*0.36+13.68*0.61+6.85*0.03)
		Appropriate Discount Rate(10.23+1)	11.23%
	c.	SALVAGE VALUE
		Annual Depreciation	$1,695,000	(13560000/8)
		Accumulated Depreciation in 5 years	$8,475,000	(1695000*5)
		Book Value at end of 5 years	$5,085,000	(13560000-8475000)
		Before tax Salvage Value	$1,640,000
		Loss on salvage	$3,445,000	(5085000-1640000)
		Tax Saving on Loss=40%*3445000	$1,378,000
		After Tax Salvage value	$3,018,000	(1640000+1378000)
	d	Annual Operating cash Flow
		Annual Sales Revenue	$169,920,000	(14400*11800)
		Variable productio Cost	$158,400,000	(14400*11000)
		Contribution Margin	$11,520,000
		Less: Fixed costs	$2,440,000
		Less: AnnualDepreciation	$1,695,000
		Profit Before Tax	$7,385,000
		After tax Profit=7385000*(1-0.4)	$4,431,000
		Add: Depreciation	$1,695,000
		Annual Operating cash Flow	$6,126,000
		Terminal Cash flow=Salvage Value+Working Capital Release+Land value	$11,953,000	(3018000+895000+8040000
							Discount rate=11.23%
		N	A	B	C	D=A+B+C	E=D/(1.1123^N)
			initial cash	Operating	Terminal	Net	Present value
		Year	flow	cash flow	Cashflow	Cash flow	PV of cashflow
		0	($22,195,000)			($22,195,000)	($22,195,000)
		1		$6,126,000		$6,126,000	$5,507,507
		2		$6,126,000		$6,126,000	$4,951,458
		3		$6,126,000		$6,126,000	$4,451,549
		4		$6,126,000		$6,126,000	$4,002,112
		5		$6,126,000	$11,953,000	$11,953,000	$7,020,487
						SUM	$3,738,113
		Net Present value (NPV)	$3,738,113
		Internal Rate of return (IRR)	17.11%	(Using IRR function of excelover Net Cash Flow)