You have been hired as a financial consultant to Defense Electronics, Inc (DEI).

Question

You have been hired as a financial consultant to Defense Electronics, Inc (DEI). The company is looking to set up a manufacturing plant overseas to produce a new product line of RDS. This will be a five-year project. The company bought some land three years ago for $4.5 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 $5.3 million. In five years, after-tax value of the land will be $5.7 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 million to build. The tax rate is 35%. The company wants to use the subjective approach to this project because it is located overseas. According to analysts the risk associated with this project will have to be adjusted by 2%. The following market data on DEI's securities apply: Debt: 230 000 7.2% coupon bonds outstanding, 25 years to maturity, selling for 108% of par: the bonds have a $1000 par value each and make semiannual payments. Ordinary shares: 8 800 000 shares issued, selling for $71 per share; the beta is 1.1. Preference shares: 450 000 shares of 5% preference shares issued, selling for $81 per share. Market: 7% expected market risk premium; 5% risk-free rate. Calculate the required return for this project for DEI.

Explanation / Answer

Market value of debt = 230,000 * ( 1.08 * 1000) = $248,400,000

Market value of ordinary equity = 8,800,000 * 71 = $624,800,000

Market value of preference shares = 450,000 * 71 = $36,450,000

Toal market value of capital structure = 248,400,000 + 624,800,000 + 36,450,000 = $910,650,000

Cost of equity using CAPM = Risk free rate + beta ( amrket risk premium)

Cost of equity = 0.05 + 1.1 ( 0.07)

Cost of equity = 0.127 or 12.7%

Price of bond = 1.08 * 1000 = $1,080

Number of periods = 25 * 2 = 50

Coupon payment = 0.072 * 1000 = 72 / 2 = 36

Before tax cost of debt = 6.5456%

Keys to use in a financial calculator: 2nd I/Y 2, FV 1000, PV -1080, N 50, PMT 36, CPT I/Y

Weighted average cost of capital = Weight of debt * after tax cost of debt + weight of equity * cost of equity + weight of preferrence shares * cost of preferrence shares

Weighted average cost of capital = (248,400,000/ 910,650,000) * 0.065456 * ( 1 - 0.35) + (624,800,000 / 910,650,000) * 0.127 + (36,450,000/ 910,650,000) * 0.05

Weighted average cost of capital = 0.011605 + 0.087135 + 0.002001

Weighted average cost of capital = 0.100741 or 10.0741%

Since the irsk needs to be adjusted by 2%

Required rate of return = 10.0741 + 2 = 12.0741%

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