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 $5.2 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 million. In five years, the aftertax 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 $32.56 million to build. The following market data on DEI’s securities is current:

Debt:	237,000 7.4 percent coupon bonds outstanding, 25 years to maturity, selling for 109 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock:	9,500,000 shares outstanding, selling for $71.70 per share; the beta is 1.2.
Preferred stock:	457,000 shares of 6 percent preferred stock outstanding, selling for $81.70 per share and and having a par value of $100.
Market:	8 percent expected market risk premium; 6 percent risk-free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 9 percent on new common stock issues, 7 percent on new preferred stock issues, and 5 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 38 percent. The project requires $1,475,000 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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)

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 +3 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.)

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 $5.2 million. What is the aftertax salvage value of this plant and equipment? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)

Aftertax salvage value           $  

d. The company will incur $7,500,000 in annual fixed costs. The plan is to manufacture 20,500 RDSs per year and sell them at $11,150 per machine; the variable production costs are $9,750 per RDS. What is the annual operating cash flow (OCF) from this project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)

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? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

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. (Enter your NPV answer in dollars, not millions of dollars, e.g., 1,234,567. Enter your IRR answer as a percent. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

IRR	%
NPV	$

Answer 1

Part a)

The value of initial time 0 cash flow is determined as below:

Initial Cash Flow at Time 0 = -(Appraised Value of Land + Cost of Building Plant and Equipment + Net Working Capital)

Substituting values in the above formula, we get,

Initial Cash Flow at Time 0 = -(6,000,000 + 32,560,000 + 1,475,000) = -$40,035,000 (answer for Part 1)

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Part b)

Step 1: Calculate Weights of Different Sources of Finance

To calculate the weight of different sources of finance, we need to determine the market value of each form of finance as below:

Market Value of Debt = Number of Bonds*Par Value*Current Selling Price Percentage = 237,000*1,000*109% = $258,330,000

Market Value of Common Stock = Number of Shares*Current Selling Price = 9,500,000*71.70 = $681,150,000

Market Value of Preferred Stock = Number of Shares*Current Selling Price = 457,000*81.70 = $37,336,900

Total Market Value of Firm = Market Value of Debt + Market Value of Common Stock + Market Value of Preferred Stock = 258,330,000 + 681,150,000 + 37,336,900 = $976,816,900

Now, we can calculate weights as follows:

Weight of Debt = Market Value of Debt/Total Market Value of Firm = 258,330,000/976,816,900

Weight of Equity = Market Value of Equity/Total Market Value of Firm = 681,150,000/976,816,900

Weight of Preferred Stock = Market Value of Preferred Stock/Total Market Value of Firm = 37,336,900/976,816,900

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Step 2: Calculate After-Tax Cost of Debt

The after-tax cost of debt can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Payment (here, Coupon Payment), PV = Present Value (here, Current Selling Price) and FV = Future Value (here, Face Value of Bonds).

Here, Nper = 25*2 = 50, PMT = 1,000*7.4%*1/2 = $37, PV = 1,000*109% = $1,090 and FV = $1,000

Using these values in the above function/formula for Rate, we get,

Pre-Tax Cost of Debt = Rate(50,37,-1090,1000)*2 = 6.66%

After-Tax Cost of Debt = Pre-Tax Cost of Debt*(1-Tax Rate) = 6.66%*(1-38%) = 4.13%

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Step 3: Calculate Cost of Preferred Stock

The cost of preferred stock is determined as below:

Cost of Preferred Stock = Annual Dividend/Current Stock Price*100 = (6%*100)/81.70*100 = 7.34%

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Step 4: Calculate Cost of Equity

The cost of equity is arrived as below:

Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium) = 6% + 1.2*(8%) = 15.60%

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Step 5: Calculate Discount Rate

The value of discount rate is calculated as follows:

Discount Rate = (Weight of Debt*After-Tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Equity*Cost of Equity) + Appropriate Risk Adjustment Factor

Substituting values in the above formula, we get,

Discount Rate = (258,330,000/976,816,900*4.13% + 37,336,900/976,816,900*7.34% + 681,150,000/976,816,900*15.60%) + 3% = 15.25% (answer for Part b)

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Part c)

The after-tax salvage value of the plant is arrived as below:

Annual Depreciation = Cost of Plant and Equipment/Useful Life = 32,560,000/8 = $4,070,000

Book Value of Plant and Equipment After 5 Years = Cost of Plant and Equipment - Annual Depreciation*5 = 32,560,000 - 4,070,000*5 = $12,210,000

Loss on Sale of Plant and Equipment = Book Value of Plant and Equipment After 5 Years - Salvage Value = 12,210,000 - 5,200,000 = $7,010,000

After-Tax Salvage Value = Salvage Value + Loss on Sale of Plant and Equipment*Tax Rate = 5,200,000 + 7,010,000*38% = $7,863,800

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Part d)

The annual operating cash flow (OCF) is determined as follows:

Sales Value (20,500*11,150)	228,575,000
Less Variable Costs (20,500*9,750)	199,875,000
Fixed Costs	7,500,000
Depreciation	4,070,000
EBT	17,130,000
Less Taxes	6,509,400
EAT	10,620,600
Add Depreciation	4,070,000
Operating Cash Flow	$14,690,600

Answer for Part d) is $14,690,600.

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Part e)

The accounting break-even quantity is calculated as follows:

Accounting Break-Even Quantity = (Fixed Cost + Depreciation)/(Selling Price - Variable Cost)

Substituting values in the above formula, we get,

Accounting Break-Even Quantity = (7,500,000 + 4,070,000)/(11,150 - 9,750) = 8,264 units (answer for Part e)

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Part f)

IRR

IRR is the minimum rate of return acceptable from a project. It can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The basic formula for calculating IRR is given below:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4 + Cash Flow Year 5/(1+IRR)^5

IRR is calculated with the use of EXCEL as below:

where

IRR = RR(B2:B7) = 29.98% or 30% (if rounded off)

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NPV

The NPV can be calculated with the use of following formula:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Discount Rate)^1 + Cash Flow Year 2/(1+Discount Rate)^2 + Cash Flow Year 3/(1+Discount Rate)^3 + Cash Flow Year 4/(1+Discount Rate)^4 + Cash Flow Year 5/(1+Discount Rate)^5

Substituting values in the above formula, we get,

NPV = -40,035,000 + 14,690,600/(1+15.25%)^1 + 14,690,600/(1+15.25%)^2 + 14,690,600/(1+15.25%)^3 + 14,690,600/(1+15.25%)^4 + (14,690,600 + 1,475,000 + 7,863,800 + 6,400,000)/(1+15.25%)^5 = $16,660,200.84

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Notes:

There can be a slight difference in final answers on account of rounding off values.