QUESTION 2: WEIGHTED AVERAGE COST OF CAPITAL (22 Marks) Defence Electronics Inte
ID: 2479986 • Letter: Q
Question
QUESTION 2: WEIGHTED AVERAGE COST OF CAPITAL (22 Marks)
Defence Electronics International (DEI) a large publicly listed company is the market leader in radar detection systems (RDSs). The company is looking to set up a manufacturing plant overseas to produce a new line of RDSs. This will be a five year project. The company bought a piece of land three years ago for $ 7 million in anticipation of using it as a toxic dump site for waste chemicals, but instead built a piping system to discard chemicals safely. If the company sold the land today it would receive $ 6.5 million after taxes. In five years the land can be sold for $4.5 million after taxes and reclamation costs. DEI wants to build a new manufacturing plant on this land. The plant will cost $15 million to build.
The following market data on DEI’s securities are current:
Debt 150,000, 12% coupon bonds outstanding with 15 years to maturity redeemable at par, selling for 80 percent of par; the bonds have a $100 par value each and make semi-annual coupon interest payments.
Equity 300,000 ordinary shares, selling for $75 per share
Non-redeemable Preference shares 20,000 shares (par value $ 100 per share) with 7.2% dividends (before taxes), selling for $72 per share The following information is relevant:
DEI’s tax rate is 30%
The company had been paying dividends on its ordinary shares consistently.
The company had been paying dividends on its ordinary shares consistently. Dividends paid during the past five years is as follows
The project requires $ 900,000 in initial net working capital investment in year 0 to become operational.
Work all solutions to the nearest two decimals. Required:
REQUIRED:
1. Calculate the project’s initial, (time 0) cash flows, taking into account all side effects. (2 MARKS)
2. Compute the current weighted average cost of capital (WACC) of DEI. Show all workings and state clearly the assumptions underlying your computations. (12 MARKS)
3. Using the WACC computed in part (2) above and assuming the following, compute the project’s Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability Index (PI)
a. The manufacturing plant has a ten-year tax life and DEI uses straight line method of depreciation for the plant. At the end of the project, (i.e. at the end of year 5), the plant can be scrapped for $ 5 million.
b. The project will incur $400,000 per annum in fixed costs
c. DEI will manufacture 15,000 RDSs per year in each of the years and sell them at $ 1,000 per machine.
d. The variable production costs are $ 500 per RDS.
e. At the end of year 5, the company will sell the land.
(6 MARKS)
4. The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Explain briefly how DEI could accommodate this additional risk factor in the determination of its discount factor? (2 MARKS)
Explanation / Answer
Answer:1 The initial cost to the company will be the opportunity cost of the land, the cost of the plant, and the net working capital cash flow, so:
CF0 = –$6,500,000 – 15,000,000 – 900,000 = –$22,400,000
Answer:2
The $7 million cost of the land 3 years ago is a sunk cost and irrelevant; the $6.5
million appraised value of the land is an opportunity cost and is relevant. The
relevant market value capitalization weights are:
MVD = 15,0000($1,00)(0.80) = $12,000,000
MVE = 300,000($75) = $22,500,000
MVP = 20,000($72) = $1,440,000
The total market value of the company is:
V = $12,000,000 + 22,500,000 + 1,440,000 = $35,940,000
Next we need to find the cost of funds. We have the information available to calculate the cost of equity using the CAPM, so:
RE = .05 + 1.3(.08) = .1540 or 15.40%
The cost of debt is the YTM of the company’s outstanding bonds, so:
P0 = $80 = $6(PVIFAR%,30) + $1,00(PVIFR%,30)
R = 7.73%
YTM = 7.73% × 2 = 15.46%
And the aftertax cost of debt is:
RD = (1 – .30)(15.46) = 10.822%
The cost of preferred stock is:
RP = $7.2/$72 10%
To find the required return on this project, we first need to calculate the WACC for the company. The company’s WACC is:
WACC = [($22.5/$35.94)(.1540) + ($1.44/$35.94)(.10) + ($12/$35.94)(10.822)] = .1366
Project required return = 13.66%
Answer:3
The annual depreciation for the equipment will be:
$15,000,000/8 = $1,875,000
So, the book value of the equipment at the end of five years will be:
BV5 = $15,000,000 – 5($1,875,000) = $5,625,000
So, the aftertax salvage value will be:
Aftertax salvage value = $5,000,000 + .30($5,625,000 – 5,000,000) = $5,18,7500.
Using the tax shield approach, the OCF for this project is:
OCF = [(P – v)Q – FC](1 – t) + tCD
OCF = [($10,00 – 5,00)(15,000) – 400,000](1 – .30) + .30($15M/8) = $5532500
The accounting breakeven sales figure for this project is:
QA = (FC + D)/(P – v) = ($400,000 + 1,875,000)/($10,00 – 5,00) = 4550 units
Discount rate 13.66% Year Cash flows 0 -22400000 1 5532500 2 5532500 3 5532500 4 5532500 5 10720000 NPV ($515,472.18) IRR 13%Related Questions
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