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

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 $7.61 million after taxes. In five years, the land will be worth $7.91 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.04 million to build. The following market data on DEI’s securities are current:

Debt: 45,100 6.9 percent coupon bonds outstanding, 21 years to maturity, selling for 94.9 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock: 751,000 shares outstanding, selling for $94.10 per share; the beta is 1.21.

Preferred stock: 35,100 shares of 6.25 percent preferred stock outstanding, selling for $92.10 per share.

Market: 7.05 percent expected market risk premium; 5.25 percent risk-free rate. DEI’s tax rate is 34 percent.

The project requires $830,000 in initial net working capital investment to get operational.

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Requirement:

(a) Calculate the net present value. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)

Explanation / Answer

Answer:(a)

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 = –$7,610,000 – 13,040,000 – 830,000 = –$21,480,000

The $7 million cost of the land 3 years ago is a sunk cost and irrelevant; the $7.61 million appraised value of the land is an opportunity cost and is relevant. The relevant market value capitalization weights are:

MVD = 45,100($1,000)(0.949) = $42,799,900

MVE = 751,000($94.10) = $70,669,100

MVP = 35,100($92.10) = $3,232710

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 = .0525 + 1.21(.0705) =13.7805%

The cost of debt is the YTM of the company’s outstanding bonds, so:

P0 = $949 = $34.5(PVIFAR%,42) + $1,000(PVIFR%,42)

R = 3.69%

YTM = 3.69% × 2 = 7.38%

And the aftertax cost of debt is:   

RD = (1 – .34)(.0738) = 4.8708%

The cost of preferred stock is:

RP = $6.25/$92.10 = .06786 or 6.786%

The annual depreciation for the equipment will be:

$13,040,000/8 = $1,630,000

So, the book value of the equipment at the end of five years will be:

BV5 = $13,040,000 – 5($1,630,000) = $4,890,000

Capital structure Market value Weight Cost of capital WACC Debt 42799900 0.3667 4.8708% 1.786% Equity 70669100 0.6056 13.7805% 8.345% Preferred shares 3232710 0.0277 6.7860% 0.188% Total 116701710 10.319%

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