Suppose you have been hired as a financial consultant to Defense Electronics, In
ID: 2383787 • 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 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 $5.8 million. In five years, the aftertax value of the land will be $6.2 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 $32.4 million to build. The following market data on DEI’s securities is current:
235,000 7 percent coupon bonds outstanding, 25 years to maturity, selling for 107 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
9,300,000 shares outstanding, selling for $71.50 per share; the beta is 1.3.
455,000 shares of 4 percent preferred stock outstanding, selling for $81.50 per share and and having a par value of $100.
6 percent expected market risk premium; 4 percent risk-free rate.
DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 7 percent on new common stock issues, 5 percent on new preferred stock issues, and 3 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 40 percent. The project requires $1,425,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally.
Calculate the project’s initial Time 0 cash flow, taking into account all side effects. Assume that the net working capital will not require floatation costs. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)
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 1 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 round your final answer to 2 decimal places. (e.g., 32.16))
The manufacturing plant has an eight-year tax life, and DEI 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 $5.0 million. What is the aftertax salvage value of this plant and equipment? (Do not round intermediate calculations.Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)
The company will incur $7,300,000 in annual fixed costs. The plan is to manufacture 19,500 RDSs per year and sell them at $11,050 per machine; the variable production costs are $9,650 per RDS. What is the annual operating cash flow (OCF) from this project? (Do not round intermediate calculations.Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)
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.)
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 your NPV answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))
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 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 $5.8 million. In five years, the aftertax value of the land will be $6.2 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 $32.4 million to build. The following market data on DEI’s securities is current:
Explanation / Answer
Project’s initial Time 0 cash flow
equipment will cost
-32400000
aftertax value of the land will be $6.2 million,
-6200000
Working Capital
-14,25,000
To find the required return on this project, we first need to calculate the WACC for the company. The company’s WACC is:
Weight
Cost ofFund
235,000 7 percent coupon bonds
251450000
0.263717
4.19%
0.011039
Common stock
664950000
0.697391
11.80%
0.082292
Preferred stock
37082500
0.038892
4.91%
0.001908
953482500
1
0.09524
WACC
9.52%
Management has told you to use an adjustment factor of 1 percent to account for this increased riskiness
10.52
Project required return =10.52
Cost of Capital computation
And the aftertax cost of debt is:
6.44
YTM =3.22 *2 =6.44%
RD = (1 – .35)(.0644)
4.19%
The cost of preferred stock is +4/81.50
4.91%
RE = .04 + 1.3(.06)
11.80%
The annual depreciation for the equipment will be
32400000
=32400000/8
4050000
So, the book value of the equipment at the end of five years will be
= 32400000-5(4050000) =12150000
12150000
So, the aftertax salvage value will be
= 5,000,000 + .35*(12150000 – 5,000,000) =7502500
7502500
Using the tax shield approach, the OCF for this project is
OCF = [(P – v)Q – FC](1 – t) + tCD
OCF = [(11050 – 9650)*19500 –(7300000)*(1 – .35) + .35(32400000/8) = 14417500
The accounting breakeven sales figure for this project is
QA = (FC + D)/(P – v)
=+(7300000+4050000)/(11050-9650)=8107
Project’s initial Time 0 cash flow
equipment will cost
-32400000
aftertax value of the land will be $6.2 million,
-6200000
Working Capital
-14,25,000
To find the required return on this project, we first need to calculate the WACC for the company. The company’s WACC is:
Weight
Cost ofFund
235,000 7 percent coupon bonds
251450000
0.263717
4.19%
0.011039
Common stock
664950000
0.697391
11.80%
0.082292
Preferred stock
37082500
0.038892
4.91%
0.001908
953482500
1
0.09524
WACC
9.52%
Management has told you to use an adjustment factor of 1 percent to account for this increased riskiness
10.52
Project required return =10.52
Cost of Capital computation
And the aftertax cost of debt is:
6.44
YTM =3.22 *2 =6.44%
RD = (1 – .35)(.0644)
4.19%
The cost of preferred stock is +4/81.50
4.91%
RE = .04 + 1.3(.06)
11.80%
The annual depreciation for the equipment will be
32400000
=32400000/8
4050000
So, the book value of the equipment at the end of five years will be
= 32400000-5(4050000) =12150000
12150000
So, the aftertax salvage value will be
= 5,000,000 + .35*(12150000 – 5,000,000) =7502500
7502500
Using the tax shield approach, the OCF for this project is
OCF = [(P – v)Q – FC](1 – t) + tCD
OCF = [(11050 – 9650)*19500 –(7300000)*(1 – .35) + .35(32400000/8) = 14417500
The accounting breakeven sales figure for this project is
QA = (FC + D)/(P – v)
=+(7300000+4050000)/(11050-9650)=8107
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.