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 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 $5.8 million. In five years, the aftertax value of the land will be $6.2 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 $32.4 million to build. The following market data on DEI’s securities is current:

Debt: 235,000 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: 9,300,000 shares outstanding, selling for $71.50 per share; the beta is 1.3.

Preferred stock: 455,000 shares of 4 percent preferred stock outstanding, selling for $81.50 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 $1,425,000 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. 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. Discount rate _____

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 $5 million. What is the aftertax salvage value of this plant and equipment? Aftertax salvage value ____

D. The company will incur $7,300,000 in annual fixed costs. The plan is to manufacture 19,500 RDSs per year and sell them at $11,050 per machine; the variable production costs are $9,650 per RDS. What is the annual operating cash flow (OCF) from this project? Operating cash flow _____

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? Break-even quantity units ______

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.

IRR %

NPV $

Answer 1

Calculating cost of capitals
We will consider the cost of capital based on market values of the types of capital.

Debt
no of bonds	235,000
Market price	1070
MV of debt	251,450,000
Settlement Date	4/17/2019
Maturity Date	4/17/2044
Price	107
Coupon rate	7%
Coupon frequency	semiannual
Yield	6.43%

'=YIELD(settlement= 4/17/19,maturity= 4/17/44,coupon rate= 7%,bond price= 107,redemption= 100,frequency= semiannual=2,1)

Pre tax cost of debt	6.43%
tax rate	40%
Post tax cost of debt	3.86%
Common stock
no of shares	9,300,000
Market price	71.5
MV of share capital	664,950,000
Beta	1.3
Rf	4%
Rm-Rf (market risk premium)	6%
Using CAPM-
Ri= Rf+ beta*(Rm-Rf)
Ri= 4%+1.3*6%	11.800%
Ri= 11.8%
Cost of common equity	11.80%
Preferred stock
no of shares	455,000
Market price	81.5
MV of share capital	37,082,500
Dividend	4.00
Implied rate of return	4.91%
	=4/81.5

Type of Capital	Market value	% of Total Capital	Cost of capital	Weighted cost of capital
Debt	251,450,000	26.37%	3.86%	1.02%
Common stock	664,950,000	69.74%	11.80%	8.23%
Preferred stock	37,082,500	3.89%	4.91%	0.19%
Total	953,482,500	100.00%		9.44%

Hence, WACC for DEI is 9.44%

A
Capital required for RDS	32,400,000
Cost of raising the capital	7%
Actual equity to be raised	34,838,710	=32,400,000/(1-7%)
Fees for Wharton	2,438,710	=34,838,710*7%
Initial cash flows-
Capital raised	34,838,710
Investments in PPE	32,400,000
Fund raising fee	2,438,710
Additional WC	1,425,000
Net cash flows	(1,425,000)
	34,838,710 - 32,400,000 - 2,438,710 - 1,425,000
B
WACC for DEI	9.44%
Risk premium for EDS	1%
Discount rate for RDS	10.44%

C
Depreciation and salvage
Year	0	1	2	3	4	5	6	7	8
PPE	32,400,000
Depreciation		4,050,000	4,050,000	4,050,000	4,050,000	4,050,000	4,050,000	4,050,000	4,050,000
Net book value of asset		28,350,000	24,300,000	20,250,000	16,200,000	12,150,000	8,100,000	4,050,000	-
Salvage price						5,000,000
Taxable Profit from salvaging						7,150,000
Tax liability from sales (@40%)						2,860,000
After tax profit from sale						4,290,000

D
Operating cash flow calculation (EBIDTA)
Year	0	1	2	3	4	5
PPE investment	32,400,000
Sales volumes		19,500	19,500	19,500	19,500	19,500
Sales price		11,050	11,050	11,050	11,050	11,050
Total Revenue		215,475,000	215,475,000	215,475,000	215,475,000	215,475,000
Variable cost per unit		9,650	9,650	9,650	9,650	9,650
Total variable cost		188,175,000	188,175,000	188,175,000	188,175,000	188,175,000
Contribution margin		27,300,000	27,300,000	27,300,000	27,300,000	27,300,000
Contribution margin		12.67%	12.67%	12.67%	12.67%	12.67%
Fixed cost		7,300,000	7,300,000	7,300,000	7,300,000	7,300,000
Operating profit		20,000,000	20,000,000	20,000,000	20,000,000	20,000,000

E
Breakeven point is sales where there is neither profit nor loss. It is calculated as follows-
BEP ($)= fixed expenses/ contribution margin ratio
BEP ($)= 7,300,000/12.67%
BEP ($)= 57,616,417

BEP (units)= fixed expenses/ contribution margin
BEP (units)= 7,300,000/(11,050-9,650)
BEP (units)= 5215

F
For NPV and IRR calculation, we need to calculate FCFF as follows-

Year	0	1	2	3	4	5
PPE investment	32,400,000
Additional WC	1,425,000
After tax salvage value						4,290,000
Sales volumes		19,500	19,500	19,500	19,500	19,500
Sales price		11,050	11,050	11,050	11,050	11,050
Total Revenue		215,475,000	215,475,000	215,475,000	215,475,000	215,475,000
Variable cost per unit		9,650	9,650	9,650	9,650	9,650
Total variable cost		188,175,000	188,175,000	188,175,000	188,175,000	188,175,000
Contribution margin		27,300,000	27,300,000	27,300,000	27,300,000	27,300,000
Contribution margin		12.67%	12.67%	12.67%	12.67%	12.67%
Fixed cost		7,300,000	7,300,000	7,300,000	7,300,000	7,300,000
Operating profit		20,000,000	20,000,000	20,000,000	20,000,000	20,000,000
less Depreciation		4,050,000	4,050,000	4,050,000	4,050,000	4,050,000
PBT		15,950,000	15,950,000	15,950,000	15,950,000	15,950,000
Tax (@40%)		6,380,000	6,380,000	6,380,000	6,380,000	6,380,000
PAT		9,570,000	9,570,000	9,570,000	9,570,000	9,570,000
FCFF	(33,825,000)	13,620,000	13,620,000	13,620,000	13,620,000	17,910,000
=PAT- WC- LT investment+ Depreciation+ salvage value
Discount rate	10.44%
Discounted PV	(33,825,000)	12,332,708	11,167,084	10,111,628	9,155,929	10,901,901
NPV	19,844,250
IRR of FCFF	30.75%