Suppose you have been hired as a financial consultant to Defense Electronics, In

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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 $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. If the land were sold today, the net proceeds would be $7.67 million after taxes. In five years, the land will be worth $7.97 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.28 million to build. The following market data on DEI

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 $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. If the land were sold today, the net proceeds would be $7.67 million after taxes. In five years, the land will be worth $7.97 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.28 million to build. The following market data on DEI

Explanation / Answer

Requirement 1:

Time 0 cash flow means cash inflow or outflow at the initial time.

In case of this project, the initial investment was the purchase of land, but that happened 3 years ago and that too for a different purpose.

Time 0 will be when the work for this project will begin i.e when $860,000 will be invested for working capital requirements.

Thus, cash flow at time 0 is -860,000

Requirement 2:

Appropriate discount rate = WACC i.e weighted average cost of capital

WACC = cost of equity*proportion of equity+cost of debt*proportion of debt

Cost of equity = Risk free rate + beta*(market return - risk free rate)

= 5.3 + 1.27*(7.1 - 5.3) = 7.59%

cost of debt = 7%. after tax cost of debt = (1-0.3)*7% = 4.9%

cost of preferred stock = 6.3%

Debt amount = no. of bonds*selling price = 45,700*943 = $43,095,100

Equity amount = no. of shares*current value = 757,000*94.7 = $71,687,900

preferred stock = no. of shares*current value = 35,700*92.7 = $3,309,390

Total capital = debt+equity stock+preference stock = $118,092,390

Percentage of debt to capital = 36.5%, equity to capital = 60.7% preferred stock to capital = 2.8%

Using WACC, cost of capital = 36.5%*4.9%+60.7%*7.59%+2.8%*6.3% = 6.47%

Adjsutment of 3% is required (as given in the question). This will be added

So, 6.47%+3% = 9.47%

Requirement 3:

Cost of plant = $13.28 million. Life = 5 years. So, under straight line method. the depreciation amount per year = 13.28 million/5 = $2.656 million.

So, the total value will be written off. Scrap value of 1.57 million will be a gain and will be taxed at 30%.

So, after tax salvage value = (1-0.3)*1.57 million = $1,099,000

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