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. (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 $7 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. If the land were sold today, the net proceeds would be $7.69 million after taxes. In five years, the land will be worth $7.99 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.36 million to build. The following market data on DEI’s securities are current:

DEI’s tax rate is 40 percent. The project requires $870,000 in initial net working capital investment to get operational.

a.
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 round 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 +2 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             %

c.
The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation. At the end of the project (i.e., the end of Year 5), the plant can be scrapped for $1.59 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 $2,390,000 in annual fixed costs. The plan is to manufacture 13,900 RDSs per year and sell them at $11,300 per machine; the variable production costs are $10,500 per RDS. What is the annual operating cash flow, 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            $

e.
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.)

Internal rate of return             %

Debt: 45,900 7.2 percent coupon bonds outstanding, 18 years to maturity, selling for 94.1 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Common stock: 759,000 shares outstanding, selling for $94.90 per share; the beta is 1.29. Preferred stock: 35,900 shares of 6.4 percent preferred stock outstanding, selling for $92.90 per share. Market: 7.2 percent expected market risk premium; 5.4 percent risk-free rate.

Explanation / Answer

1 Initial Investment - Cost of machine 13360000 Increase in Net Working capital - 870000 14230000 2 WACC - (a) Cost of debt and market value Price of bond = PV of cash flows discounted at Yield 1000 x 94.1% = 1000 x 7.2% x 6/12 x (PVAF YTM, 18 x 2) + 1000 x PVIF (YTM, 18 x 2) 941 = 36 x PVAF(YTM, 36) + 1000/(1+YTM)^36 Using linear interpolation - r= Price 3% 1130.99 r 941.00 4% 924.37 r-3/4-3 = (941-1130.99)/(924.37-1130.99) r-3 = 0.9195 x 1 r = 3 + 0.9195 r = 3.9195 for 6 months 0r 7.839 for year Post tax KD = 7.839 x (1-0.4)= 4.7034 Market value of bond = 45900 x 941 = 43191900 (b) Value of stock and Ke Ke = Rf + (Rm-Rf) x B Ke = 5.4 + 7.4 x 1.29 = 14.946 Market Value = (759000 x 94.9) = 72029100 ( C) Value and cost of prefered stock - Kp = Dividend rate 6.5 Market value = 35900 x 92.9 3335110 Securities Weights Cost W X C (W) ( C) Debt 43191900 4.7034 203148782.5 Stock 72029100 14.946 1076546929 Prefered stock 3335110 6.5 21678215 118556110 1301373926 WACC = 1301373926/118556110 x 100 10.9769 3 Post tax salvage value - Salvage value at the end ofproject = 1590000 Book value 0f machine - Cost - 13360000 Less : Depreciation (cost x 5/8) 8350000 5010000 Loss on sale - -3420000 Tax savings - -1368000 Post tax salvage value - 2958000 4 Calculation of Annual operating cash flows Sales (13900 x 11300) 157070000 Less: Variable cost (13900 x 10500) 145950000 Contribution 11120000 Less: Fixed cost 2390000 Less: depreciation (cost/8) 1670000 Incremental EBIT 7060000 Less Tax @ 40% 2824000 PAT 4236000 Add: Depreciation 1670000 OCF 5906000 5 NPV - 0 1 to 4 5 Initial Investments -14230000 OCF 5906000 5906000 Post tax salvage value 2958000 Recovery of NWC 870000 Net Cash flows -14230000 5906000 9734000 PV factors @ WACC 1 3.1040 0.5940703 PV of cash flows -14230000 18332100 5782680 NPV = 9884780.273 6 IRR - Using linear interpolation - r= NPV 34% 6020.33 r 0.00 35% -265212.15 r-34/35-34 = (0-6020.33)/(-265212.15-6020.33) r-34 = 0.02220 x 1 r = 34.02% Project is acceptable as it has a positive NPV and IRR more then WACC. Please provide feedback…. Thanks in advance…. :-)

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