Suppose you have been hired as a financial consultant to Defense Electronics, In
ID: 2804246 • Letter: S
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 $5.2 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 $6 million. In five years, the aftertax value of the land will be $6.4 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 $32.56 million to build. The following market data on DEl's securities are current Debt 237,000 7.4 percent coupon bonds outstanding, 25 years to maturity, selling for 109 percent of par, the bonds have a $1,000 par value each and make semiannual payments 9,500,000 shares outstanding, selling for $71.70 per share, the beta is 1.2 457,000 shares of 6 percent preferred stock outstanding, selling for $81.70 per share 8 percent expected market risk premium; 6 percent risk-free rate Common stock: Preferred stock: Market DEl uses G.M. Wharton as its lead underwriter. Wharton charges DEl spreads of 9 percent on new common stock issues, 7 percent on new preferred stock issues, and 5 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. DEI's tax rate is 38 percent. The project requires $1,475,000 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, e.g. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32.) Cash flovw 17025 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 +3 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI's project. (Do not round intermediate calculations. 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 DEl uses straight-line depreciation. At the end of the project (that is, the end of year 5), the plant and equipment can be scrapped for $5.2 million. What is the aftertax salvage value of this plant and equipment? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32) Aftertax salvage valueExplanation / Answer
MVD = 237,000 ($1000) (1.09) = $258,330,000
MVE = 9,500,000 ($71.70) = $681,150,000
MVP = 457,000 ($81.70) = $37,336,900
The total market value of the company is
V = $258,330,000 + $681,150,000 + $37,336,900
V = $976,816,900
Next, we need to find the cost of funds. Using CAPM, the cost of equity is
Re = 6 + 1.2 (8 – 6)
Re = 8.4%
The cost of debt is the YTM of the company is outstanding bonds, so using YTM approximation.
YTM = [I + (F – P)/n]/ (F + P)/2
YTM = [74 + (1000 – 1090)/25]/ (1000 + 1090)/2
YTM = 6.65%
And the after-tax cost of debt is
RD = 6.65 %*(1 – 0.38)
RD = 4.12%
The cost of preferred stock is
Rp = $6/$81.70
Rp = 0.0734 or 7.34%
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 = –$5,200,000 – 32,560,000 – 1,475,000 = –$39,235,000
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 = [($25.833/$97.68169)(.0412) + ($68.115/$97.68169)(.084) + ($3.73369/$97.68169)(.0734)] = .0723
The company wants to use the subjective approach to this project because it is located overseas. The adjustment factor is 3 percent, so the required return on this project is:
Project required return = .0723 + .03 = .1023
c. The annual depreciation for the equipment will be:
$32,560,000/8 = $4,070,000
So, the book value of the equipment at the end of five years will be:
BV5 = $32,560,000 – 5($4,070,000) = $12,210,000
So, the aftertax salvage value will be:
Aftertax salvage value = $5,200,000 + .38($12,210,000 – 5,200,000) = $7,863,800
d. Using the tax shield approach, the OCF for this project is:
OCF = [(P – v)Q – FC](1 – t) + tCD
OCF = [($11,150 – 9750)(20,500) – 7,500,000](1 – .38) + .38($32.56M/8) = $14,690,600
e. The accounting breakeven sales figure for this project is:
QA = (FC + D)/(P – v) = ($7,500,000 + 4,070,000)/($11,150 – 9,750) = 8,264 units
f. We have calculated all cash flows of the project. We just need to make sure that in Year 5 we add back the aftertax salvage value, the recovery of the initial NWC, and the aftertax value of the land. The cash flows for the project are:
Year Flow Cash
0 –$39,235,000
1 14,690,600
2 14,690,600
3 14,690,600
4 14,690,600
5 30,429,400
Using the required return of 10.23 percent, the NPV of the project is:
NPV = –$39,235,000 + $14,690,600(PVIFA10.23%,4) + $30,429,400/1.10235
NPV = $34,826,222.77
And the IRR is:
NPV = 0 = –$39,235,000 + $14,690,600(PVIFAIRR%,4) + $30,429,400/(1 + IRR)5
IRR = 30.94%
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