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 $7.73 million after taxes. In five years, the land will be worth $8.03 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.52 million to build. The following market data on DEI’s securities are current: Debt: 46,300 7.1 percent coupon bonds outstanding, 19 years to maturity, selling for 93.7 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Common stock: 763,000 shares outstanding, selling for $95.30 per share; the beta is 1.16. Preferred stock: 36,300 shares of 6.35 percent preferred stock outstanding, selling for $93.30 per share. Market: 7.15 percent expected market risk premium; 5.35 percent risk-free rate. DEI’s tax rate is 38 percent. The project requires $890,000 in initial net working capital investment to get operational.

Requirement 1: Calculate the project’s Time 0 cash flow, taking into account all side effects. Assume that any NWC raised does not require floatation costs.

Requirement 2: 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 +3 percent to account for this increased riskiness. What is the discount rate

Requirement 3: The manufacturing plant has an eight-year tax life, and DEI uses straightline depreciation. At the end of the project (i.e., the end of year 5), the plant can be scrapped for $1.63 million. What is the aftertax salvage value of this manufacturing plant?

Requirement 4: The company will incur $2,430,000 in annual fixed costs. The plan is to manufacture 14,300 RDSs per year and sell them at $11,700 per machine; the variable production costs are $10,900 per RDS. What is the annual operating cash flow, OCF, from this project?

Requirement 5: (a) Calculate the net present value. (b) Calculate the internal rate of return.

Explanation / Answer

1. Intial Cash Flow at Time 0

2.

3.

4 & 5.

Initial Cash Inflow Land Cost $      (7,730,000.00) Plant Cost $   (13,520,000.00) Initial Working Capital $         (890,000.00) Inititial Cash Flow $   (22,140,000.00)

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