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

ID: 2793806 • Letter: S

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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 $5.5 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 $6.3 million. In five years, the aftertax value of the land will be $6.7 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 $32.80 million to build. The following market data on DEI’s securities are current:

240,000 7.4 percent coupon bonds outstanding, 25 years to maturity, selling for 107 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

9,800,000 shares outstanding, selling for $71.90 per share; the beta is 1.2.

460,000 shares of 6 percent preferred stock outstanding, selling for $82.00 per share.

8 percent expected market risk premium; 6 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 $1,550,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally and that the NWC does not require floatation costs..

Calculate the project’s initial time 0 cash flow, taking into account all side effects. (Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount.)

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 and round your final answer 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 $5.5 million. What is the aftertax salvage value of this plant and equipment? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations.)

The company will incur $7,800,000 in annual fixed costs. The plan is to manufacture 22,000 RDSs per year and sell them at $11,300 per machine; the variable production costs are $9,900 per RDS. What is the annual operating cash flow (OCF) from this project? (Enter your answer in dollars, not millions of dollars, i.e. 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 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. (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Explanation / Answer

a) Initial Cash Flow Cost of Land -$6,300,000 Cost of Plant (calculated below) -$35,612,075.84 Net Working Capital -$1,550,000 Cash flow at Time 0 -$43,462,075.84 weighted Floatation Cost Market Value (calculated below) Weights Floatation Cost Weighted flotation cost Debt $256,800,000 25.70% 5.00% 1.29% Common Stock $704,620,000 70.52% 9.00% 6.35% Preferred Stock $37,720,000 3.78% 7.00% 0.26% Total $999,140,000 100.00% 7.90% Amount raised for cost of Plant = Amount raised (1-7.90%) = 32,800,000 $35,612,075.84 b. The new XYZ project is somewhat riskier than a typical project for ASE primarily because the plant is being located overseas. Management has told you to use an adjustment factor of 1 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating AESI’s project. First Compute WACC Market Value Weights Cost WACC Debt $256,800,000 25.70% 4.22% 1.09% Common Stock $704,620,000 70.52% 15.60% 11.00% Preferred Stock $37,720,000 3.78% 7.32% 0.28% Total $999,140,000 100.00% 12.36% WACC 12.36% Adjustment factor 3.00% Discount rate 15.36% Debt Face Value $1,000 Coupon Payment = 1000 x 7.4%/2 $37 Nper = 25 x 2 50 Present Value = $1000 x 107% 1070 Semi Annual Cost of Debt = YTM = Rate 3.41% Annual Cost of Debt after tax =2 x 3.41% x (1-38%) 4.22% Market Value = 240,000 x $1070 $256,800,000 Common Stock Cost of Equity = Risk free rate + Beta x Market Risk Premium = 6% + 1.2 x 8% 15.60% Market Value = 9800000 shares x $71.90 $704,620,000 Preferred Stock Cost of Preferred = Dividend/ Price = $100 x 6% / $82 7.32% Market Value = 460,000 shares x $82 $37,720,000 c.The manufacturing plant has an eight-year tax life, and ASE 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 $5.5 million. What is the aftertax salvage value of this plant and equipment? Annual depreciation for the equipment = $32800000 /8 $4,100,000 Book value = $32800000 - (5 x 4100000) $12,300,000 Aftertax salvage value = $5,500,000 + (38% x (12,300,000 - 5,500,000) $8,084,000 d.The company will incur $7,000,000 in annual fixed costs. The plan is to manufacture 18,000 RDSs per year and sell them at $10,900 per machine; the variable production costs are $9,500 per RDS. What is the annual operating cash flow (OCF) from this project? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) OCF = [(P – v)Q – FC](1 – t) + tCD OCF = [($11,300 – 9,900)(22,000) – 7,800,000](1 – .38) + .38($32.80M/8) $15,818,000 e.ASE’s comptroller is primarily interested in the impact of ASE’s investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of XYZs sold for this project? e. Accounting breakeven = QA = (FC + D)/(P – v) = ($7,800,000 + 4,100,000)/($11,300 – 9,900) $8,500 units f.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. Year Cashflow PV @15.36% Present Value 0 -$43,462,075.84 1.0000 -$43,462,075.84 1 $15,818,000 0.8668 $13,711,446.47 2 $15,818,000 0.7514 $11,885,432.06 3 $15,818,000 0.6513 $10,302,596.12 4 $15,818,000 0.5646 $8,930,553.5 5 $32,152,000 0.4894 $15,734,991.03 NPV $17,102,943.33 IRR 29.41% Cashflow in 5th year = OCF + NWC + Residual value + aftertax value of the land

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