QUESTION 2: WEIGHTED AVERAGE COST OF CAPITAL (22 Marks) Defence Electronics Inte

Question

QUESTION 2: WEIGHTED AVERAGE COST OF CAPITAL (22 Marks)
Defence Electronics International (DEI) a large publicly listed company is the market leader in radar detection systems (RDSs). The company is looking to set up a manufacturing plant overseas to produce a new line of RDSs. This will be a five year project. The company bought a piece of land three years ago for $ 7 million in anticipation of using it as a toxic dump site for waste chemicals, but instead built a piping system to discard chemicals safely. If the company sold the land today it would receive $ 6.5 million after taxes. In five years the land can be sold for $4.5 million after taxes and reclamation costs. DEI wants to build a new manufacturing plant on this land. The plant will cost $15 million to build. The following market data on DEI’s securities are current:
Debt
150,000, 12% coupon bonds outstanding with 15 years to maturity redeemable at par, selling for 80 percent of par; the bonds have a $100 par value each and make semi-annual coupon interest payments.
Equity
300,000 ordinary shares, selling for $75 per share
Non-redeemable Preference shares
20,000 shares (par value $ 100 per share) with 7.2% dividends (before taxes), selling for $72 per share
The following information is relevant:
DEI’s tax rate is 30%
The company had been paying dividends on its ordinary shares consistently. Dividends paid during the past five years is as follows
Year (-5) ($) 2.2
Year (-4) ($) 2.5
Year (-3) ($) 2.8
Year (-2) ($) 3.3
Year (-1) ($) 3.6

The project requires $ 900,000 in initial net working capital investment in year 0 to become operational.
Work all solutions to the nearest two decimals.
Required:
1. Calculate the project’s initial, (time 0) cash flows, taking into account all side effects.
(2 MARKS)
2. Compute the current weighted average cost of capital (WACC) of DEI. Show all workings and state clearly the assumptions underlying your computations.
(12 MARKS)
3. Using the WACC computed in part (2) above and assuming the following, compute the project’s Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability Index (PI)
a. The manufacturing plant has a ten-year tax life and DEI uses straight line method of depreciation for the plant. At the end of the project, (i.e. at the end of year 5), the plant can be scrapped for $ 5 million.
Page 5 of 6
b. The project will incur $400,000 per annum in fixed costs
c. DEI will manufacture 15,000 RDSs per year in each of the years and sell them at $ 1,000 per machine.
d. The variable production costs are $ 500 per RDS.
e. At the end of year 5, the company will sell the land.
(6 MARKS)
4. The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Explain briefly how DEI could accommodate this additional risk factor in the determination of its discount factor?
(2 MARKS)

please show all the process details so i can understand the answer

Explanation / Answer

4) the discount rate is to be increased considering the country risk; a premium for the country risk may be added to the WACC. This is arbitrary and should be carefully applied as other wise acceptable projects may be rejected or rejectable projects might be accepted.

1)PROJECTS INITIAL CASH FLOW: $ plant and equipment 15000000 value of land (after taxes) if sold 6500000 (opportunity cost) Addl Working Capital required 900000 22400000 2) Current WACC a) Cost of debt-Kd: after tax cost of debt (half yearly) can be found out by solving for 'I' from the following equation: by trial and error: 80 = 100*pvif(i,30) + 6*0.7*pvifa(i,30) discounting with 5% pv = 100*0.2314 + 4.2*15.3725 = 23.14+64.56 = 87.70 discounting with 6% pv = 100*0.1741+ 4.2*13.7648 = 17.41+57.81 = 75.22 interpolating, i = 5+7.7/12.48 = 5.6170 Kd = 5.6170*2 =11.23% b) cost of preferred stock-Kp: 7.2/72 = 10% c) cost of equity-Ke: growth rate to be found out from the equation 3.6=2.2*(1+g)^4 1.6364 = (1+g)^4 g=1.1310 - 1 = 0.1310 = 13.1% Ke = D1/P0 + g = 3.6*1.131/75 + 0.131 = 0.1853 =18.53% specific MV weights: MV wt cost WACC debt = 150000*80 12000000 0.33 11.23 3.75 preference=20000*72 1440000 0.04 10.00 0.40 equity=300000*75 22500000 0.63 18.53 11.60 35940000 15.75 3) NPV, IRR & PI: Terminal cash flows: Sale value of land after taxes 4500000 P&E Depreciation per year = (15000000)/10 = 1500000 Book Value at the end of the 5th year = 15000000 -5*1500000 = 7500000 Salvage value 5000000 Loss on sale 2500000 tax shield on loss 750000 Net after tax salvage value of P&E 5750000 Total terminal cash flows 10250000 PV = 10250000*pvif(15.75,5) =10250000*0.4813= 4933325 Annual Operating Cash flows: Contribution on 15000 RDS = 15000*(1000-500) 7500000 fixed costs -400000 depreciation -1500000 profit before tax 5600000 tax at 30% 1680000 profit after tax 3920000 add depreciation 1500000 Annual operating cash flows 5420000 PV=5420000*pvifa(15.75,5)= 5420000*3.2935 17850770 NPV = 17850770+4933325-22400000 = 384095 PI = (17850770+4933325)/22400000= 1.02 1.02 IRR 22400000 = 5420000*pvifa(i,5) + 10250000*pvif(i,5) using 17% PV = 5420000*3.1993+10250000*4561 = 22015231 using 15.75% PV = 22784095 IRR = 15.75 + 384095/*1.25(22784095-22015231) = 15.75 +1.25* 384095/768864 = 16.37%

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