Suppose you have been hired as a financial consultant to Defence Electronics Inc

Question

Suppose you have been hired as a financial consultant to Defence 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 $3.9 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 $4.4 million. In five years, the after-tax value of the land will be $4.8 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 will cost $37 million to build. The following market data on DEI’s securities are current: Debt: 210,000 6.4 percent coupon bonds outstanding, 25 years to maturity, selling for 108 percent of par; the bonds have a $1,000 par value each and make semiannual payments Common stock: 8,300,000 shares outstanding, selling for $68 per share; the beta is 1.1 Preferred stock: 450,000 shares of 4.5 percent preferred stock outstanding, selling for $81 per share Market: 7 percent expected market risk premium; 3.5 percent risk-free rate DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 8 percent on new common stock issues, 6 percent on new preferred stock issues, and 4 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 35 percent. The project requires $1,300,000 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 the answer in dollars. Do not round intermediate calculations. Round the final answer to the nearest whole dollar.) 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 12 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project. (Do not round intermediate calculations. Round the final answer to 2 decimal places.) Discount rate %

c. The manufacturing plant belongs to CCA Class 43 (30%). At the end of the project (that is, the end of Year 5), the plant can be scrapped for $5.1 million. What is the PVCCATS of this plant and equipment? (Enter the answer in dollars. Do not round intermediate calculations. Round the final answer to the nearest whole dollar.) Aftertax salvage value $

d. The company will incur $6,700,000 in annual fixed costs. The plan is to manufacture 15,300 RDSs per year and sell them at $11,450 per machine; the variable production costs are $9,500 per RDS. What is the annual operating cash flow (OCF) from this project? (Enter the answer in dollars. Do not round intermediate calculations. Round the final answer to the nearest whole dollar.) Operating cash flow $

e. 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. Round the final answer to nearest whole number.) Break-even quantity 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. (Enter the NPV in dollars. Enter the IRR as a percent. Do not round intermediate calculations. Round the final answers to 2 decimal places.) IRR % NPV $

Explanation / Answer

a) Initial Cash Flow Cost of Land -$4,400,000 Cost of Plant (calculated below) -$39,706,303.75 Net Working Capital -$1,300,000 Cash flow at Time 0 -$45,406,303.75 weighted Floatation Cost Market Value (calculated below) Weights Floatation Cost Debt $226,800,000 27.40% 4.00% Common Stock $564,400,000 68.19% 8.00% Preferred Stock $36,450,000 4.40% 6.00% Total $827,650,000 100.00% Amount raised for cost of Plant = Amount raised (1-6.82%) = 37,000,000 $39,706,303.75 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 Debt $226,800,000 27.40% 3.76% Common Stock $564,400,000 68.19% 11.20% Preferred Stock $36,450,000 4.40% 5.56% Total $827,650,000 100.00% WACC 8.91% Adjustment factor 12.00% Discount rate 20.91% Debt Face Value $1,000 Coupon Payment = 1000 x 6.4%/2 $32 Nper = 25 x 2 50 Present Value = $1000 x 108% 1080 Semi Annual Cost of Debt = YTM = Rate 2.90% Annual Cost of Debt after tax =2 x 2.90% x (1-35%) 3.76% Market Value = 210,000 x $1080 $226,800,000 Common Stock Cost of Equity = Risk free rate + Beta x Market Risk Premium = 3.5% + 1.1 x 7% 11.20% Market Value = 8300000 shares x $68 $564,400,000 Preferred Stock Cost of Preferred = Dividend/ Price = $100 x 4.5% / $81 5.56% Market Value = 450,000 shares x $81 $36,450,000

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