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

ID: 2752044 • 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 $7.72 million after taxes. In five years, the land will be worth $8.02 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.48 million to build. The following market data on DEI’s securities are current:

Debt:

46,200 7 percent coupon bonds outstanding, 22 years to maturity, selling for 93.8 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock: 762,000 shares outstanding, selling for $95.20 per share; the beta is 1.17.

Preferred stock: 36,200 shares of 6.3 percent preferred stock outstanding, selling for $93.20 per share.

Market: 7.1 percent expected market risk premium; 5.3 percent risk-free rate.

DEI’s tax rate is 30 percent. The project requires $885,000 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. (Do not round intermediate calculations. Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)

Initial Time 0 cash flow $

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 +2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

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 $1.62 million. What is the aftertax salvage value of this manufacturing plant? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)

Aftertax salvage value $

Requirement 4:

The company will incur $2,420,000 in annual fixed costs. The plan is to manufacture 14,200 RDSs per year and sell them at $11,600 per machine; the variable production costs are $10,800 per RDS. What is the annual operating cash flow, OCF, from this project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)

Operating cash flow $

Requirement 5:
(a)

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

Net present value $

(b)

Calculate the internal rate of return. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

Internal rate of return %

Explanation / Answer

Requirement 1:

The initial Investment for the plant is $13.48 Million.

The opportunity cost of using the land and not selling today would be 7.72 – 7.00 =0.72 Million.

Hence the cash outflow at time 0 would also include this opportunity cost. Hence it would be 13.48 + 0.72 = 14.2 Million = $14,200,000.

Requirement 2: Discount rate:

The discount rate for the project is calcauted as the WACC

Cost of debt is given by YTM which is calculated as per the excel formula =rate(nper,pmt,pv,fv)

=rate(22*2,0.07*1000/2,-938,1000)*2 (Since it is semi annual payment)

=0.075837

After tax cost of debt will be 0.075837*(1-0.3) = 0.0531 = 5.31%

Hence Rd = 0.0531 =5.31%

Cost of equity is given by CAPM formula

Re = Rf + beta*(Rm –Rf ) = 0.053 + 1.17*(0.071-0.053) = 7.41%

Hence Cost of equity = Re = 0.0741 = 7,41%

Cost of preferred shares = Dividend/ Current Share price = 6.3/93.20 = 0.0676

Rp = 6.76% = 0.0676

Total Debt = 46,200*938 = $43,335,600

Total Equity 762,000 * 95.20 = $72,542,400

Total Preference shares: 36,200*93.20 = 3,373,840

Weight of debt = Wd = 43335600/119251840 = 0.3634

Weight of equity = We = 0.6083

Wp = 0.0283

Hence WACC = 0.3634*0.0531 + 0.6083*0.0741 + 0.0283*0.0676 = 6.63%

Hence with an addition of 2% discount rate is 8.63%

Requirement 3:

Accounting to deprecation per year (straight line): 13,480,000/8 = 1,685,000 for one year.

So for 5 years the value Is 5*1685000 = 8425000. Hence book value = 13480000-8425000 = $5,055,000

Since the sale value is 1,620,000 which is less than the book value, tax is zero.

Hence salvage value is also 1,620,000

Requirement 4

The operating Cash flow is as shown below:

Year

Initial Investment

-13480000

Revenue

164720000

Variable Cost

153360000

Fixed Cost

2420000

Depriciation

1685000

Profit before Tax

7255000

Tax at 30%

2176500

Profit after Tax

5078500

Salvage Value

1620000

Add deprciation

1685000

Total Operating Cash flow

-13480000

6763500

8383500

Requirement 5

NPV of the project as per excel at 8.83% discount rate calculated in part 2 is $ 1,30,28,734.60

The IRR for the project is calculated as 42.51% as per excel

The project can be accepted as IRR greater than discount rate

Year

Initial Investment

-13480000

Revenue

164720000

Variable Cost

153360000

Fixed Cost

2420000

Depriciation

1685000

Profit before Tax

7255000

Tax at 30%

2176500

Profit after Tax

5078500

Salvage Value

1620000

Add deprciation

1685000

Total Operating Cash flow

-13480000

6763500

8383500

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