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

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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 $3.9 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. The land was appraised last week for $4.7 million. In five years, the aftertax value of the land will be $5.1 million, but the company expects to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost $31.52 million to build. The following market data on DEI’s securities is current: Debt: 224,000 7.4 percent coupon bonds outstanding, 25 years to maturity, selling for 109 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Common stock: 8,200,000 shares outstanding, selling for $70.40 per share; the beta is 1.2. Preferred stock: 444,000 shares of 4 percent preferred stock outstanding, selling for $80.40 per share and and having a par value of $100. Market: 6 percent expected market risk premium; 4 percent risk-free rate. DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 9 percent on new common stock issues, 7 percent on new preferred stock issues, and 5 percent on new debt issues. Wharton has included all direct and indirect issuance costs (along with its profit) in setting these spreads. Wharton has recommended to DEI that it raise the funds needed to build the plant by issuing new shares of common stock. DEI’s tax rate is 38 percent. The project requires $1,150,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally.

Calculate the project’s initial Time 0 cash flow, taking into account all side effects. Assume that the net working capital will not require flotation costs. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)

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

The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation. At the end of the project (that is, the end of Year 5), the plant and equipment can be scrapped for $3.9 million. What is the aftertax salvage value of this plant and equipment? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)

The company will incur $6,200,000 in annual fixed costs. The plan is to manufacture 14,000 RDSs per year and sell them at $10,500 per machine; the variable production costs are $9,100 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).)

DEI’s comptroller is primarily interested in the impact of DEI’s investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of RDSs sold for this project? (Do not round intermediate calculations and round your final answer to the nearest whole number.)

Finally, DEI’s president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the RDS project’s internal rate of return (IRR) and net present value (NPV) are. Assume that the net working capital will not require flotation costs. (Enter your NPV answer in dollars, not millions of dollars (e.g., 1,234,567). Enter your IRR answer as a percent. Do not round intermediate calculations and round your final answers to 2 decimal places (e.g., 32.16).)

Explanation / Answer

Part 1)

The value of initial investment is calculated as follows:

Initial Investment = -Value of Land Today - Cost of Plant and Equipment - Increase in Working Capital

Using the values provided in the question, we get,

Initial Investment = -4,700,000 - 31,5200,00 - 1150,000 = -$37,370,000

Part 2)

The discount rate can be calculated with the WACC (Weighted Average Cost of Capital) formula which is given below:

WACC = After-Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

Market Value of Debt = Number of Bonds*Par Value*Current Selling Price = 22400*1,000*109% = $24,416000

Market Value of Preferred Stock = Number of Preferred Shares*Current Price = 444000*80.40 = $3,56,97,600

Market Value of Equity = Number of Common Shares*Current Price = 8200,000*70.40= $5,772,80,000

Total Market Value = 24416000 + 3,5697600+ 577280000 = $5,837,393,600

Weight of Debt = 24416000/5837393600=0.004182

Weight of Preferred Stock = 3,5697600/5837393600=0.006115

Weight of Common Stock = 577380000/5837393600=0.0989

Now, we need to calculate cost of debt, equity and preferred stock.

The cost of debt can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Coupon Payment, PV = Current Selling Price and FV = Face Value of Bonds

Here, Nper = 25*2 = 50, PMT = 1,000*7.4%*1/2 = $37, PV = 1,000*109% = $1090 and FV = $1,000

Using these values in the above function/formula for Rate, we get,

After-Tax Cost of Debt = Rate(50,37,-1090,1000)*2*(1-35%) = 3.328%

Cost of Preferred Stock = Annual Dividend/Current Price*100 = (4%*100)/80.40*100 = 4.98%

Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium) = 4% + 1.2*6% = 7.6%

WACC = 0.004182*3.32% + 3,283,750/117,628,750*4.98% + 71,347,500/117,628,750*7.6% = 7.90%

Discount Rate = WACC + Risk Adjustment Factor = 7.90% + 1% =8.90

Part 3)

The after-tax salvage value is calculated as follows:

Annual Depreciation = Cost of Plant/Estimated Life = 31520,000/10 = $3152000

Book Value of Plant after 5 Years = 31520000 - 3152,000*5 = $15760,000

After-Tax Salvage Value = Sales Value - Tax*(Sales Value - Book Value) = 3.900,000 - 38%*(3900,000 - 15760,000) = $606800

Operating cash flow = (Sales - Variable cost - Fixed cost - Depreciation)* (1 - Tax) + Depreciation

= ((14000*10500) - (14000 * 9100) - 6200000 - (31520000/5)) * (1 - .38) + (31520000/5)

= 10,703,520

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

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