Suppose you have been hired as a financial consultant to Defense Electronics, In
ID: 2795494 • Letter: S
Question
Suppose you have been hired as a financial consultant to Defense Electronics, Inc. (DEl), 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 sit for waste chemicals, but it built a piping system to safely discard the chemicals instead· lf the land were sold today, the net proceeds would be $7.74 million after taxes. In five years, the land will be worth $8.04 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.56 million to build. The following market data on DEl's securities are current: 46,400 7.2 percent coupon bonds outstanding, 18 years to maturity, selling for 93.6 percent of par, the bonds have a $1,000 par value each and make semiannual payments. Debt: Common stock: 764,000 shares outstanding, selling for $95.40 per share; the beta is 1.15 Preferred stock: 36,400 shares of 6.4 percent preferred stock outstanding, selling for S93.40 per share. 7.2 percent expected market risk premium; 5.4 percent risk-free rate DEI's tax rate is 40 percent. The project requires $895,000 in initial net working capital investment to get operational Calculate the project's Time 0 cash flow, taking into account all side effects. Assume that any NWC raised does not require floatation costs. (A negative answer should be indicated by a minus sign. Do not rou intermediate calculations and enter your answer in dollars, not millions of dollars, e.g., 1,234,567.) Time 0 cash flow b. 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 +1 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 enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Discount rate The manufacturing plant has an eight-year tax life, and DEl uses straight-line depreciation. At the end of the project i.e., the end of Year 5), the plant can be scrapped for $1.64 million. What is the aftertax salvage value of this manufacturing plant? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, e.g., 1,234,567.) Aftertax salvage value d. The company will incur $2,440,000 in annual fixed costs. The plan is to manufacture 14,400 RDSs per year and sell them at $11,800 per machine; the variable production costs are $11,000 per RDS. What is the annual operating cash fiow, OCF, from this project? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, e.g., 1,234,567.) Operating cash flow Calculate the project's net present value. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g. 32.16.) Net present value Calculate the project's internal rate of return. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)Explanation / Answer
First of all let's use CAPM Model to determine the cost of equity
As per CAPM Model, Cost of equity= risk free rate+ beta*Market risk premium
therefore, cost of equity= 5.4+1.15*7.2=13.68
This essentially is cost of common equity which amounts to 764,000*95.4= 72,885,600/-
Cost of preferred stock is 6.4% which amounts to 36400*96.4=3,508,960/-
Our third source of capital is debt which is in the form of bonds with par value of $ 1000 and selling at 93.6% of par vlaue i.e. 93.6%*1000= $936
Therefore, total value of debt = 46,400*936 (this is because we have 46,400 number of bonds)
= $ 43,430,400
Now we need to find out cost of debt i.e. yield to maturity of bond for which we have the following information:
Bond Price = $ 936 i.e. Current price or present value
Future price or value = $ 1000 (i.e. face value which the bond will pay on maturity)
7.2% Coupon (paid semiannually) , therefore coupon paid half yearly= 7.2%/2 * $ 1000= $ 36
Years to maturity = 18 , no of periods to maturity considering that there are two periods per year (as the coupon is paid semiannually) = 18*2 = 36
So, FV= $ 1000, PV=$ 936, N= 36 , PMT= $ 36, CPT I/Y, this gives us I/Y= 3.94% , you can arrive at this figure by using Rate formula in excel or using your financial calculator or any of the online tools available for calculating yield to maturity, there can be slight difference in value that you get using different modes, that is due to approximation error,however, we can live with that. Also, you will get 3.94/2 =1.97% while calculating because you have used periods so yield to maturity is for one period is 1.97% , multiply it with no of periods per year i.e.2 in this case to get yield to maturity per year
Now we can calculate the cost of capital using the output we got for costs of different sources of capital as follows:
= cost of common equity* proportion of common equity+ cost of debt * proportion of debt + cost of preferred stock* proportion of preferred stock
Total capital= 72885600+3508960+43,430,400= 119,824,960
= 13.68%* 72885600/ 119,824,960+6.4%*3508960/119824960+3.94%*43430400/119824960 (1- 40%)= 8.32%+0.19%+1.43%*0.6= 9.4%, note that that interest payments on bonds are tax free and hence the cost of capital due to debt is adjusted for tax effect using factor (1-40%)...........................(1)
This is the cost of capital for our company given the capital structure, for any project to be taken future value of cash flows discounted at this rate should be positive otherwise the project should not be taken
Value of the land today = $ 7.74 million
Value of the land five years from now= $ 8.04 million
Cost of building the plant = $ 13.56 million
Net working capital required to build the project = $ 895,000
Therefore, the project's time 0 cash flow would be = $ 13.56 million+ $ 895,000= $ 13.56 million + $ 0.895 million= $ 14.455 million
this is excluding land cost , if we factor in land cost as well, then total cost of setting up the project or time T=0 cash flows= $ 14.455 million + land cost today= $ 14.455+ $ 7.74= $ 22.195 million....this is the answer to question 1
Now, management advises that being an overseas project, we need to add a +1 factor to the discount factor , therefore discount rate = cost of capital + 1% = 9.4%+1% =10.4% (we have calculated cost of capital above , refer (1))...............this is answer to question 2
We know the initial cost of buidling the plant is $ 13.56 million (this is excluding land cost and NWC required for setting up project). Now it is given that the life of the project is 8 years as per tax file,however plant life taken by company is 5 years, so depreciation per year as per life of 5 years = Value ofplant - value of scrap/ plant life = ($13.56-$1.64)/5= $ 2.384.................(2)
Now, we are given that life of project is 8 years as per tax file ,therefore annual depreciation as per tax file = $ 2.384*5/8= $ 1.49 , therefore, total depreciaiton = $ 1.49*8= $ 11.92, salvage value = $ 13.56- $ 11.92= $1.64, this is just to show that life of the project will effect the amount of annual depreciation but has no effect on salvage or scrap value which will remain the same i.e. $ 1.64 million, now this is before tax, after tax value would be $ 1.64*0.6= $ 0.984 million
Question 4: no of units to be manufactured= 14,400, selling price per unit= $ 11,800, total revenue= $ 169,920,000
total variable costs = $ 11000* 14400=$ 158,400,000
Annual fixed costs = $ 2,440,000
Total costs= variable costs+ fixed costs= $ 158,400,000+ $ 2,440,000= $ 160,840,000
Profit before tax= Total sales- total costs= $ 169,920,000- $ 160,840,000= $ 9,080,000
Profit after tax= 0.6* $ 9,080,000= $ 5,448,000
Now taking the value of depreciation as per project life of 5 years i.e. value in $ 2.384 million, this being a non cash expense , it need not be taken into considering while calculating operating cash flow
Therefore, profit after tax calculated above is essentially the annual operating cash flow, however,this cash flow is cash flow to the firm and not to equity holders, generally, the operating cash flow is stated after subtracting the interest cost . If we are to calculate annual operating cash flow to common equity holders then we need to deduce annual cost incurred on account of part financing of the project through preferred stock holders and annual cost incurred on account of payments made to bond holders
Please post the remaining questions separately, just to give you a hint you simply need to use NPV and IRR formula respectively for solving questions 5 and 6 on the project cash flows estimated above
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