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 looing 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 $7.76 million after taxes. In five years, the land will be worth $8.06 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.64 million to build. The following market data on DEl's securities are current: 46,600 6.9 percent coupon bonds outstanding, 21 years to maturity, selling for 93.4 percent of par; the bonds have a $1,000 par value each and make semiannual payments Debt 766,000 shares outstanding, selling for $95.60 per share; the beta is 1.13 36,600 shares of 6.25 percent preferred stock outstanding, selling for $93.60 per 7.05 percent expected market risk premium; 5.25 percent risk-free rate Common stock: Preferred stock: are Market: DEI's tax rate is 34 percent. The project requires $905,000 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 DEl, 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. Calculate the appropriate discount rate to use when evaluating DEl's project. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) Discount rate

Explanation / Answer

Requirement 1:

Projects Tim 0 cash flows = Cost of Land (Opportunity Cost) + Project Building Cost + Initial working capital investment

= 7,760,000 + 13,640,000 + 905,000 = -22,305,000

Requirement 2:

Market Value Debt = 46,600 x 1000 x 93.4% = 43,524,400

Market Value Equity = 766,000 x 95.60 = 73,229,600

Market Value Preferred Stock = 36,600 x 93.6 = 3,425,760

Total Market Value of Company = 120,179,760

Cost of Equity using CAPM = 5.25% + 1.13 x 7.05% = 13.22%

Cost of debt = YTM of outstanding bonds = 7.53%

After tax cost of debt = (1 – 34%) x 7.53% = 4.97%

Cost of preferred stock = 6.25 / 93.6 = 6.68%

Weighted average cost of capital = 43,524,400/120,179,760 x 4.97% + 73,229,600/120,179,760 x 13.22% + 3,425,760 / 120,179,760 x 6.68% = 10.05%

Project Risk Premium = 3%

Hence discount rate = 13.05%

Requirement 3:

Annual depreciation = 13,640,000/8 = 1,705,000

After tax Salvage value = 1,660,000 + 0.34 x ( 13,640,000 – 1,705,000 x 5 – 1,660,000)

= 2,834,700

Requirement 4:

Operating Cash Flow = [ (12,000 – 11,200) x 14,600 – 2,460,000] x (1 – 0.34) + 0.34 x 13,640,000/8

= 6,664,900

Requirement 5:

NPV

Year 0: -22,305,000 / Year 1 – 4 : 6,664,900 / Year 5: 18,464,600 (OCF + Working Capital + Salvage Value + Cost of Land)

Discounting at 13.05% NPV = 7,498,678.52

IRR = 24.03%

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