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. (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 $4.1 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 $4.9 million. In five years, the aftertax value of the land will be $5.3 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 $31.68 million to build. The following market data on DEl's securities are current 226,000 7.0 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 Debt payments. Common stock 8,400,000 shares outstanding, selling for $70.60 per share; the beta is 1.3. Preferred stock 446,000 shares of 4 percent preferred stock outstanding, selling for $80.60 per share 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 7 percent on nevw common stock issues, 5 percent on new preferred stock issues, and 3 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 DEl that it raise the funds needed to build the plant by issuing new shares of common stock. DElI's tax rate is 40 percent. The project requires $1,200,000 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. a. 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.) Cash flow

Explanation / Answer

Solution:

The $4.1 million cost of the land 3 years ago is a sunk cost and irrelevant; the $5.3

million appraised value of the land is an opportunity cost and is relevant. The

relevant market value capitalization weights are:

MVD = 226,000($1,000)(1.07) = $241,820,000

       MVE = 8,400,000($70.60) = $593,040,000

       MVP = 446,000($80.60) = $35,947,600

The total market value of the company is:

V = $241,820,000 + $593,040,000 + $35,947,600

V = $870,807,600

Next we need to find the cost of funds. We have the information available to calculate the cost of equity using the CAPM, so:

       RE = .04 + 1.3(.06) = .118 or 11.80%

The cost of debt is the YTM of the company’s outstanding bonds, so:

       P0 = $1070 = $35(PVIFAR%,50) + $1,000(PVIFR%,50)

       R = 3.22%

YTM = 3.22% × 2 = 6.433%

       And the aftertax cost of debt is:          

       RD = (1 – .4)(.06433) = .0386 or 3.86%

The cost of preferred stock is:

       RP = $4/$80.60 = .0496 or 4.96%

a.    The initial cost to the company will be the opportunity cost of the land, the cost of the plant, and the net working capital cash flow, so:

               CF0 = –$5,300,000 – 31,680,000 – 1,200,000 = –$38,180,000

b.    To find the required return on this project, we first need to calculate the WACC for the company. The company’s WACC is:

               WACC = [($593,040,000/$870,807,600)(.118) + ($35,947,600/$870,807,600)(.0496) + ($241,820,000/$870,807,600)(.0386)] = .09313

               The company wants to use the subjective approach to this project because it is located overseas. The adjustment factor is 1 percent, so the required return on this project is:

               Project required return = .09313 + .01 = .1031

c.

The annual depreciation for the equipment will be:

               $31,680,000/8 = $3,960,000

               So, the book value of the equipment at the end of five years will be:

               BV5 = $31,680,000 – 5($3,960,000) = $11,880,000

               So, the aftertax salvage value will be:

So, the aftertax salvage value will be:

              

               Aftertax salvage value = $4,100,000 + .4($11,880,000 – 4,100,000) = $7,212,000

d.    Using the tax shield approach, the OCF for this project is:

              

               OCF = [(P – v)Q – FC](1 – t) + tCD

               OCF = [($10,600 – 9,200)(15,000) – 6,400,000](1 – .4) + .4($31.68M/8) = $10,344,000

e.

The accounting breakeven sales figure for this project is:

                 QA = (FC + D)/(P – v) = ($6,400,000 + 3,960,000)/($10,600 – 9,200) = 7,400 units

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