Suppose you have been hired as a financial consultant to Defense Electronics, In

ID: 2383481 • Letter: S

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 $4.2 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 $5 million. In five years, the aftertax value of the land will be $5.4 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 $31.76 million to build. The following market data on DEI’s securities is current:

227,000 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.

8,500,000 shares outstanding, selling for $70.70 per share; the beta is 1.2.

447,000 shares of 6 percent preferred stock outstanding, selling for $80.70 per share and and having a par value of $100.

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 $1,225,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally.

Calculate the project’s initial Time 0 cash flow, taking into account all side effects. Assume that the net working capital will not require floatation costs. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

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 and round your final answer to 2 decimal places. (e.g., 32.16))

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 $4.2 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, i.e. 1,234,567.)

The company will incur $6,500,000 in annual fixed costs. The plan is to manufacture 15,500 RDSs per year and sell them at $10,650 per machine; the variable production costs are $9,250 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, i.e. 1,234,567.)

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.)

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 answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Explanation / Answer

Since, there are multiple partsand the question is really long, the first 4 parts have been answered.

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Part a)

The initial cash flow (in Year 0) will comprise of the appraised value of land, cost of building plant and equipment after adjustment for flotation costs and net working capital. The following formula can be used for calculating the initial year cash flow:

Initial Year Cash Flow = Appraised Value of Land + Cost of Building Plant and Equipment*(1-Weighted Average Flotation Cost) + Net Working Capital

Weighted Average Flotation Cost = Market Value of Debt/Total Value of the Firm*Debt Flotation Cost + Market Value of Preferred Stock/Total Value of the Firm*Preferred Stock Flotation Cost + Market Value of Equity/Total Value of the Firm*Equity Flotation Cost

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Using the values provided in the question, we get,

Weighted Average Flotation Cost = (227,000*1000*109%)/(227,000*1000*109% + 447,000*80.70 + 8,500,000*70.70)*5% + (447,000*80.70)/(227,000*1000*109% + 447,000*80.70 + 8,500,000*70.70)*7% + (8,500,000*70.70)/(227,000*1000*109% + 447,000*80.70 + 8,500,000*70.70)*9% = 7.80%

Initial Year Cash Flow = 5,000,000 + 31,760,000/(1-7.80%) + 1,225,000 = $40,671,854.66 or $40,671,855

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Part b)

To calculate the discount rate, we need to find the weighted average cost of capital. The formula for calculating weighted average cost of capital is given below:

WACC = After Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

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Cost of Debt:

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

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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,

Cost of Debt = Rate(50,37,-1090,1000)*2 = 6.66% (we multiply by 2 to get annual cost of debt)

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

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Cost of Preferred Stock = Annual Dividend/Current Price*100 = (6%*100)/80.70*100 =7.43%

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Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium) = 6 + 1.2*8 = 15.6%

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WACC = (227,000*1000*109%)/(227,000*1000*109% + 447,000*80.70 + 8,500,000*70.70)*4.13% + (447,000*80.70)/(227,000*1000*109% + 447,000*80.70 + 8,500,000*70.70)*7.43% + (8,500,000*70.70)/(227,000*1000*109% + 447,000*80.70 + 8,500,000*70.70)*15.60% = 12.06%

Appropriate Discount Factor after Adjustment for Risk = WACC + Adjustment Factor = 12.06% + 3 = 15.06%

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Part C)

The formula for calculating after-tax salvage value is:

After-Tax Salvage Value = Salvage Value -/+ Tax on Gain or Loss Realized on Salvage Value

Gain/Loss = Salvage Value - Book Value

Book Value = Cost - Depreciation upto the Year of Sale

Depreciation = Cost/Estimated Life

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Annual Depreciation = 31,760,000/8 = 3,970,000

Book Value = 31,760,000 - 3,970,000*5 = 11,910,000

Gain/Loss = 4,200,000 - 11,910,000 = 7,710,000

After-Tax Salvage Value = 4,200,000 + 34%*7,710,000 = $6,821,400

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Part D)

Annual Operating Cash Flow Table:

Sales (15,500*10,650) 165,075,000 Variable Costs (15,500*9,250) 143,375,000 Fixed Costs 6,500,000 Depreciation 3,970,000 EBIT 11,230,000 Taxes (11,230,000*38%) 4,267,400 Net Income 6,962,600 Depreciation 3,970,000 Operating Cash Flow $10,932,600

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Suppose you have been hired as a financial consultant to Defence Electronics Inc

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