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 $7.66 million after taxes. In five years, the land will be worth $7.96 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.24 million to build. The following market data on DEI’s securities are current:

DEI’s tax rate is 34 percent. The project requires $855,000 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 $1.56 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 $2,360,000 in annual fixed costs. The plan is to manufacture 13,600 RDSs per year and sell them at $11,000 per machine; the variable production costs are $10,200 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: 45,600 6.9 percent coupon bonds outstanding, 21 years to maturity, selling for 94.4 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Common stock: 756,000 shares outstanding, selling for $94.60 per share; the beta is 1.26. Preferred stock: 35,600 shares of 6.25 percent preferred stock outstanding, selling for $92.60 per share. Market: 7.05 percent expected market risk premium; 5.25 percent risk-free rate.

Explanation / Answer

a) The project’s Time 0 cash flow The $7 million cost of the land 3 years ago is a sunk cost and irrelevant; the $7.66 million million appraised value of the land is an opportunity cost and is relevant. Land -$7,660,000 Cost of Plant -$13,240,000 Initial Working Capital -$855,000 Cash flow@ Time 0 -$21,755,000 b) First Compute WACC Market Value Weights Cost WACC Debt $43,046,400 36.52% 4.90% 1.79% Common Stock $71,517,600 60.68% 14.13% 8.58% Preferred Stock $3,296,560 2.80% 6.75% 0.19% Total $117,860,560 100.00% 10.56% WACC 10.56% Adjustment factor 2.00% Discount rate 12.56% Debt Face Value $1,000 Coupon Payment = 1000 x 6.9%/2 $34.5 Nper = 21 x 2 42 Present Value = $1000 x 94.4% 944 Semi Annual Cost of Debt = YTM = Rate 3.72% Annual Cost of Debt after tax =2 x 3.72% x (1-34%) 4.90% Market Value = 45,600 x $944 $43,046,400 Common Stock Cost of Equity = Risk free rate + Beta x Market Risk Premium = 5.25% + 1.26 x 7.05% 14.13% Market Value = 756000 shares x $94.60 $71,517,600 Preferred Stock Cost of Preferred = Dividend/ Price = $100 x 6.25% / $92.60 6.75% Market Value = 35600 shares x $92.60 $3,296,560 c) Annual depreciation for the equipment = $13240000 /8 $1,655,000 Book value = $13,240,000 - (5 x 1655000) $4,965,000 Aftertax salvage value = $1,560,000 + (34% x (4965000 - 1,560,000) $2,717,700 d)The company will incur $2,360,000 in annual fixed costs. The plan is to manufacture 13,600 RDSs per year and sell them at $11,000 per machine; the variable production costs are $10,200 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.) OCF = [(P – v)Q – FC](1 – t) + tCD OCF = [($11,000 – 10,200)(13,600) – 2,360,000](1 – .34) + .34($13.24M/8) $6,185,900 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 @12.56% Present Value 0 -$21,755,000 1.0000 -$21,755,000 1 $6,185,900 0.8884 $5,495,847.75 2 $6,185,900 0.7893 $4,882,772.52 3 $6,185,900 0.7013 $4,338,087.32 4 $6,185,900 0.6231 $3,854,163.09 5 $17,718,600 0.5536 $9,808,179.27 NPV $6,624,049.95 IRR 22.41% Cashflow in 5th year = OCF + NWC + Residual value + aftertax value of the land

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