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 $4.7 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. The land was appraised last week for $5.5 million. In five years, the aftertax value of the land will be $5.9 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 $32.16 million to build. The following market data on DEI’s securities are current: Debt: 232,000 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. Common stock: 9,000,000 shares outstanding, selling for $71.20 per share; the beta is 1.3. Preferred stock: 452,000 shares of 4 percent preferred stock outstanding, selling for $81.20 per share. Market: 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 $1,350,000 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 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 +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. 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 (that is, the end of year 5), the plant and equipment can be scrapped for $4.7 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 value $ d. The company will incur $7,000,000 in annual fixed costs. The plan is to manufacture 18,000 RDSs per year and sell them at $10,900 per machine; the variable production costs are $9,500 per RDS. What is the annual operating cash flow (OCF) from this project? (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.) 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 and round your final answer to nearest whole number, e.g., 32.) 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 your NPV in dollars, not millions of dollars, e.g., 1,234,567. Enter your IRR as a percent. Do not round intermediate calculations and round your final answers to 2 decimal places, e.g., 32.16.)

Explanation / Answer

Note: The NPV is positive. Hence, the project can be undertaken.

a) INITIAL TIME '0' CASH FLOW: cost of P & E 32160000 value of land (opportunity cost) 5500000 tax on gain on sale of land -320000 (55000000-4700000)*0.4 NWC 1350000 Net initial cash outflow at time '0' 38690000 b) Discount rate to be used: GM Wharton has advised to use external equity. Hence, the discount rate should be the cost of new equity with a premium of +1% for riskiness. Cost of equity as per CAPM = 4 + 1.3*6 = 11.8% cost of new equity after considering 7% spread = 11.8/0.93 = 12.73 discount rate to be used = cost of new equity 12.73% + premium for risk 1% = 13.73% c) After tax salvage value of the P&E: straight line depreciation = 32160000/8 = 4020000 BV at the end of the 5th year = 32160000 - 5*4020000 = 12060000 scrap value at the end of 5 years 4700000 loss: on disposal - 12060000 - 4700000 7360000 tax shield on loss at 40% 2944000 after tax salvage value = 4700000 + 2944000 7644000 d) Annual operating cash flows: contribution (10900-9500)*18000 25200000 less: fixed costs 7000000 less: depreciation 4020000 operating profit before tax 14180000 tax @ 40% 5672000 profit after tax 8508000 add: depreciation 4020000 operating cash flows after tax 12528000 e) Accounting break even quantity: BEP in units = fixed costs/contribution per unit = 11020000/1400 = 7871 units. f) NPV: PV of operating cash flows = 12528000*pvifa(13.73,5) = 12528000*3.4555 43290504 PV of salvage value + release of NWC = (7644000+135000)*pvif(13.73,5) 7779000*0.5256 4088642 PV of cash inflows from the project 47379146 less: initial investment 38690000 NPV 8689146 IRR: IRR is that discount rate for which NPV = 0: ie: 12528000*pvifa(irr,5) + 7779000*pvif(irr,5) = 38690000 The value of irr can be solved by trial and error or an irr calculator Using an irr calculator it is 22.07 (check for irr = 12528000*pvifa(22.07,5) + 7779000*pvif(22.07,5) 12528000*2.8594 + 7779000*0.3689 = 38692236 which is close to the initial cost of 38690000)

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