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

ID: 2384085 • 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 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 $4.8 million. In five years, the aftertax value of the land will be $5.2 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 $31.6 million to build. The following market data on DEI’s securities is current:

Debt:

225,000 7.2 percent coupon bonds outstanding, 25 years to maturity, selling for 108 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock:

8,300,000 shares outstanding, selling for $70.50 per share; the beta is 1.1.

Preferred stock:

445,000 shares of 5 percent preferred stock outstanding, selling for $80.50 per share and and having a par value of $100.

Market:

7 percent expected market risk premium; 5 percent risk-free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 8 percent on new common stock issues, 6 percent on new preferred stock issues, and 4 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 35 percent. The project requires $1,175,000 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.)

Cash flow

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 2 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))

Discount rate

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 $4.0 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.)

Aftertax salvage value

The company will incur $6,300,000 in annual fixed costs. The plan is to manufacture 14,500 RDSs per year and sell them at $10,550 per machine; the variable production costs are $9,150 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.)

Operating cash flow

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.)

Break-even quantity

units

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))

IRR

NPV

Explanation / Answer

Answer To Question a

Cash Outflow required at t=0 = Initial investment in project + working capital investment + floatation costs

Since the project is financed with equity we need to consider the floatation costs of equity

Floatation costs for equity : 31.6 Million * 0.08 = 2528000

We are assuming over here that floatation costs are capitalized, hence are not eligible for tax deduction. If it were however expensed, tax paid on floatation costs would have to be considered as an inflow.

Initial Cash Outflow at T= 0 :

= 31600000 + 1175000 + 2528000 = 35303000

We did not take land value as an outflow as it has already been incurred and hence treated as sunk cost

Answer To Question b

The appropriate discount rate to be used is cost of equity as the project is to be financed with equity.

Equity Discount Rate (as given by CAPM) = Risk free Rate + Beta * Market premium

Or equity disc rate = 5% + 1.1 * 7% = 12.7%

Company wants to adjust its risk by 2%. Hence the appropriate discount rate should be : 12.7% + 2% = 14.7%

Note that we did not account for floatation cost in cost of capital as it is one time cost and hence forms part of initial investment.

Answer To Question c

After tax salvage value is given as : Salvage value + Tax shield on loss ( Book Value – Salvage value)

Book Value at the end of five years needs to be calculated

Yearly Depreciation = 31.6 million / 8 = 3950000

Hence book value of plant at end of 5 years = 3950000 * 3 = 11850000

After tax salvage value = 4000000 + 0.35( 11850000 – 4000000)

= 6747500

Answer To Question d

Calculation of Annual Operating Cash Flow

Contribution ( 10550 – 9150 ) * 14500

20300000

Less: Fixed Costs

6300000

Operating Income

14000000

Less: Tax @ 35%

4900000

Operating Cash Flow

9100000

Answer To Question e

Break even quantity = Fixed Costs / Contribution per unit

= 6300000 / (10550 – 9150 ) = 4500 units

Answer To Question f

Net present Value Calculation

= PV(Cash Inflow Year 1-5) – Cash Outflow at T=0

= 9100000 from Year 1 to 5 discounted @ 14.7% + 6747500 discounted for 5th year @ 14.7% + Working Capital Released ( 1175000 discounted for 5th year @ 14.7%) - 35303000

= PVIFA (14.7% , 5) = 3.376 and present value of $ 1 at 5 year end @ 14.7% = 0.503

= 3.376 * 9100000 + 0.503 * (6747500+1175000) – 35303000

= - $ 620150

Since NPV is negative project is not worthwhile.

Calculation of IRR

35303000 = 9100000/(1+r) + 9100000/(1+r)2 + 9100000/(1+r)3 + 9100000/(1+r)4 + 9100000/(1+r)5 + 6747500/(1+r)5 + 1175000/(1+r)5

Since our NPV is less than zero so IRR must be less than 14.7% i.e our cost of equity.

Assuming trial and error method, if we plug r as 14 % the R.H.S. of above equation will give result of 35355000 which is marginally close to L.H.S.

Since RHS> LHS we now decide to increase the rate as 14.1% and then we will get RHS as 35255100 which again is less than LHS

So by above results we could arrive at the conclusion that IRR of the project = 14.00%

Contribution ( 10550 – 9150 ) * 14500

20300000

Less: Fixed Costs

6300000

Operating Income

14000000

Less: Tax @ 35%

4900000

Operating Cash Flow

9100000

Navigate

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

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.

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

Question

Explanation / Answer

Related Questions

Navigate