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

ID: 2645270 • 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 $7 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. If the land were sold today, the net proceeds would be $7.74 million after taxes. In five years, the land will be worth $8.04 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.56 million to build. The following market data on DEI

Explanation / Answer

Part a)

The cash flow in Year/Time 0 will comprise of cost of building plant and net working capital required. The cost of land acquired 3 years ago will be treated as sunk cost and hence not included in the initial year cash flow. The formula for calculating time 0 cash flow would be:

Time 0 Cash Flow = Cost of Building Plant + Net Working Capital

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Solution:

Using the information provided in the question, we get,

Time 0 Cash Flow = -13,560,000 - 895,000 = -$14,455,000

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Part b)

We need to calculate the weighted average cost of capital. The formula for calculating WACC is:

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

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Step 1 Calculate Cost of Debt, Preferred Stock and Equity

Cost of debt can be calculated with the use of EXCEL/Financial Calculator. The formula/function for calculating after pre-tax cost of debt would be Rate(Nper,PMT,-PV,FV) where Rate = Cost of Debt, Nper = Period, PMT = Interest Payment, PV = Present Value of Bonds and FV = Face Value.

Here, Nper = 18*2 = 36, PMT = 1,000*7.2%*1/2 = $36, PV = 1,000*93.60% = $936 and FV = 1,000

Using these values in the above function, we get,

Pre-tax Cost of Debt = Rate(36,36,-936,1000)*2 = 7.87% (we multiply by 2 because rate is to be calculated annually)

After Tax Cost of Debt = Pre-tax Cost of Debt*(1-Tax Rate) = 7.87%*(1-40%) = 4.72%

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The formula for calculating cost of preferred stock is:

Cost of Preferred Stock = Annual Dividend/Current Stock Price*100

Here, Annual Dividend = 6.4%*100 = $6.4 and Current Stock Price = $93.40

Using these values in the above formula, we get,

Cost of Preferred Stock = 6.4/93.40*100 = 6.85%

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We need to use the CAPM model to determine the cost of equity. The formula for calculating cost of equity is:

Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium)

Using the values provided in the question, we get,

Cost of Equity = 5.4 + 1.15*(7.2) = 13.68%

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Step 2 Calculate Weight of Debt, Preferred Stock and Equity

Weight of debt, preferred stock and equity will be calculated with the use of their respective market values and total market value of the firm.

Total Market Value of the Firm = Market Value of Debt + Market Value of Preferred Stock + Market Value of Equity

Market Value of Debt = Number of Bonds*Face Value*Current Selling Price % = 46,400*1,000*93.60% = $43,430,400

Market Value of Preferred Stock = Number of Shares*Current Selling Price = 36,400*93.40 = $3,399,760

Market Value of Common Stock = Number of Shares*Current Selling Price = 764,000*95.40 = $72,885,600

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Weight of Debt = 43,430,400/(43,430,400 + 3,399,760 + 72,885,600)

Weight of Preferred Stock = 3,399,760/(43,430,400 + 3,399,760 + 72,885,600)

Weight of Equity = 72,885,600/(43,430,400 + 3,399,760 + 72,885,600)

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Step 3 Calculate WACC

Using the above calculated values in the formula for WACC, we get,

WACC (Without Risk Adjustment) = 4.72%*43,430,400/(43,430,400 + 3,399,760 + 72,885,600) + 6.85%*3,399,760/(43,430,400 + 3,399,760 + 72,885,600) + 13.68%*72,885,600/(43,430,400 + 3,399,760 + 72,885,600) = 10.24%

WACC (With Risk Adjustment) = 10.24% + 1% = 11.24% (Discount Rate)

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

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

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