Suppose you have been hired as a financial consultant to Defense Electronics, In
ID: 2733988 • 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 $7.73 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.) Project’s Time 0 cash flow Plant Cost $13.52 Million Initial NWC $0.89 Million Total $14.41 Million 2.) Calculation of Original Discount Rate or WACC(Weighted Average Cost of Capital) Type of Security Quantity Rate Value Weight Cost of Capital Weighted Cost Debt 46300 937 43383100 0.37 4.40% 1.63% Common Stock 763000 95.3 72713900 0.62 13.64% 8.45% Preferred Stock 36300 36.3 1317690 0.01 6.35% 0.07% Total 117414690 WACC 10.15% Note 1 Calculation of Ke i.e. Cost of equity Ke = Risk Free Return + Beta(Market Return - Risf free Return) = 5.35% + 1.16(7.15%) =13.644% Note 2 Calculation of Kd i.e. Cost of debt Kd = Int Rate (I-tax rate) Bond 1 = 7.1%(1-38%) =4.40% Revised or Adjusted Discount Rate = Original Discount Rate + Adjustment =10.15%+3% =13.15% 3.) Sale Value at the end $1.3 Million Book Value as per tax regime $5.07 Million Loss on sale $3.77 Million Tax benefit @ 38% on loss $1.4326Million Net Cash Inflow $2.7326 Million Note : 3 Book value as per tax regime Original Cost of Plant $13.52 Million Depreciation Per Year $1.69 Million Depreciation for 5 years $8.45 Million Closing Value at year 5 $5.07 Million 4.) Calculation of Annual Cash Flow Particulars Quantity Rate Value Revenue 14300 11700 167310000 Variable Cost 14300 10900 155870000 Contribution Margin 11440000 Less: Fixed Cost 2430000 Annual Cash Flow 9010000 5) Calculation of NPV Year Cash Flows($) Present Value Factor @13.15% Present Value 0 -14410000 1 -14410000 1 9010000 0.884 7962881.1 2 9010000 0.781 7037455.7 3 9010000 0.690 6219580.8 4 9010000 0.610 5496757.2 5 9010000 0.539 4857938.4 5 3626000 0.539 1954414.0 Net Present Value (NPV) 19119027.3 Note: Year 5 will include sale of plant as computred in point 3 and realisation of working capital initially introduced
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