Suppose you have been hired as a financial consultant to Defense Electronics, In
ID: 2629539 • 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 $4.3 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 $5.1 million. In five years, the aftertax value of the land will be $5.5 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 $31.84 million to build.
228,000 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.
8,600,000 shares outstanding, selling for $70.80 per share; the beta is 1.1.
448,000 shares of 5 percent preferred stock outstanding, selling for $80.80 per share and and having a par value of $100.
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
Debt:228,000 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:8,600,000 shares outstanding, selling for $70.80 per share; the beta is 1.1.
Preferred stock:448,000 shares of 5 percent preferred stock outstanding, selling for $80.80 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
Explanation / Answer
a) Initial Time Cash Flow: Total Capital to be raised would be Funds Required for Cost of Building Plant and Net Working Capital i.e. 31,840,000+1250000 33,090,000.00 We assume that this capital will be raised in the current weights for Capital i.e. Source of Capital Weight Capital Required Net of Floatation Cost Flotation Cost Gross Capital to be issued Common Stock 68.31% 22,604,536.38 1,965,611.86 24,570,148.24 Preferred Stock 4.06% 1,343,857.66 85,778.15 1,429,635.80 Debt 27.63% 9,141,605.96 380,900.25 9,522,506.21 Total 33,090,000.00 2,432,290.26 35,522,290.26 Initial Time Cash Flow: Particulars Amount Cost of building plant $ 31,840,000.00 Net Working Capital $ 1,250,000.00 Opportunity Cost of Land $ 5,500,000.00 Flotation Costs: Common Stock $ 1,965,611.86 Preferred Stock $ 85,778.15 Debt $ 380,900.25 Total Flotation Costs $ 2,432,290.26 Total Initial Time Cash Flow $ 35,522,290.26 Note: The cost of land is a sunk cost. Therefore, not considered in decision making. But at present it can be sold for $5.5 million if not used in project. Therefore, it is considered as opportunity costs. b) Calculation of Weighted Average Cost of Capital: Cost of Debt: Par Value $1,000.00 Market Price (108% * $1,000) $1,080.00 Future Value $1,000.00 Coupon Rate (7.2%/2) 3.60% Nper / Time (25 years * 2) 50.00 Flotation Cost 4.00% PMT = Par Value * Coupon Rate PMT = $1,000 * 3.60% PMT $36.00 Flotation Costs = Flotation Costs Percentage * Market Price Flotation Costs = 4% * $1,080 Flotation Costs $43.20 Present Value = Market Price - Flotation Costs Present Value = $1,080 - $36.00 Present Value $1,036.80 Using excel formula, Rate (Yield Semi-annual) 3.44% Annual Yield (3.44% * 2) 6.89% After tax Cost of debt = Pretax Cost of Debt * (1 - Tax Rate) After tax cost of debt = 6.89% * (1 - 35%) After tax cost of debt 4.48% Cost of Preferred Stock: Par Value $100.00 Market Price $80.80 Dividend Rate 5.00% Flotation Costs 6.00% Dividend = Par Value * Dividend Rate Dividend = $100 * 5.00% Dividend $ 5.00 Flotation Costs = Flotation Costs Percentage * Market Price Flotation Costs = 6% * $80.80 Flotation Costs $ 4.85 Net Proceeds = Market Price - Flotation Costs Net Proceeds = $80.80 - $4.85 Net Proceeds $ 75.95 Cost of Preferred Stock = Dividend / Net Proceeds Cost of Preferred Stock = $5.00 / $75.95 Cost of Preferred Stock 6.58% Cost of Equity: Cost of Equity = Risk Free Rate + Beta * Market Risk Premium Cost of Equity = 5% + 1.1 * 7% Cost of Equity 12.70% Calculation of Weights: Source Market Value Weight Debt $ 246,240,000.00 27.63% Preferred Stock $ 36,198,400.00 4.06% Common Stock $ 608,880,000.00 68.31% Total $ 891,318,400.00 100.00% Calculation of Weighted Average Cost of Capital: Source Weights Cost WACC Debt 27.63% 4.48% 1.24% Preferred Stock 4.06% 6.58% 0.27% Common Stock 68.31% 12.70% 8.68% WACC 10.18% Appropriate Weighted Average Cost of Capital = 10.18% + 2% Appropriate WACC 12.18% c) Depreciation = Purchase Cost / Useful Life Depreciation = $31,840,000 / 8 years Depreciation $ 3,980,000.00 Written Down Value = Purchase Cost - Total Depreciation in 5 years Written Down Value = $31,840,000 - ($3,980,000 * 5 years) Written Down Value $ 11,940,000.00 After tax Salvage Value: Particulars Amount Salvage Value $4,300,000.00 Written Down Value $11,940,000.00 Loss $(7,640,000.00) Tax Savings @ 35% $(2,674,000.00) After tax Salvage Value $6,974,000.00 d) Annual Operating Cash Flow: Particulars Amount Sales Revenue $ 171,200,000.00 Less: Variable Cost $ 148,800,000.00 Less: Fixed Costs $6,600,000.00 Less: Depreciation $3,980,000.00 Profit before tax $ 11,820,000.00 Less: Taxes @ 35% $ 4,137,000.00 Profit after tax $ 7,683,000.00 Add: Depreciation $ 3,980,000.00 Operating Cash Flow $ 11,663,000.00 e) Accounting and Financial Breakeven Quantity Breakeven Point of Sales is that Quantity where Sales would be equal to all the expenses including Variable Cost, Fixed Cost, Depreciation Breakeven Point (in units) Contribution / Selling Price - Variable Cost Contribution= (Fixed Costs + Depreciation) $10,580,000.00 Breakeven Point (in uints) 7,557 Breakeven Point (in Sales) $80,861,429 f) Calculation of Net Present Value Net Present Value = Present Value of Cash Inflows Less Present Value of Cash Outflows Present Value of Cash Inflows Amount per annum Present Value Fact @12.18% Present Value Operating Cash Inflows (Year 1 to Year 5) $11,663,000.00 3.59 $41,855,703.51 Working Capital $1,250,000.00 0.37 $466,308.76 Opportunity Cost of Land (5th Year) $5,500,000.00 0.37 $2,051,758.53 Present Value of Cash Inflows $44,373,770.80 Present Value of Cash Outflows {from a)} -$35,522,290.26 1 -$35,522,290.26 Net Present Value $8,851,480.54 Calculation of Internal Rate of Return 31% For Computing IRR we would interpolare above computed Cash Flows along with the Cash flows discounted at 33% Cash flows @ 33% Present Value of Cash Inflows Amount per annum Present Value Fact @33% Present Value Operating Cash Inflows (Year 1 to Year 5) $11,663,000.00 2.30 $26,849,873.88 Working Capital $1,300,000.00 0.24 $312,381.39 Opportunity Cost of Land (5th Year) $6,000,000.00 0.24 $1,441,760.24 Present Value of Cash Inflows $28,604,015.51 Present Value of Cash Outflows {from a)} -$35,522,290.26 1 -$35,522,290.26 Net Present Value -$6,918,274.75 Interpolating, NPV Cost of Capital NPV 12.41 $8,851,480.54 33 -$6,918,274.75 Difference 20.59 -$15,769,755.29 IRR= 23.97 As NPV is positive , we recommend to invest in the project.
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