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 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 $5.1 million. In five years, the after-tax value of the land will be $6 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 $35 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 $4 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 $5.1 million. In five years, the after-tax value of the land will be $6 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 $35 million to build. The following market data on DEI

Explanation / Answer

The $7 million cost of the land 3 years ago is a sunk cost and irrelevant; the $6.5

million appraised value of the land is an opportunity cost and is relevant. The

relevant market value capitalization weights are:

       MVD = 15,000($1,000)(0.92) = $13,800,000

       MVE = 300,000($75) = $22,500,000

       MVP = 20,000($72) = $1,440,000

       The total market value of the company is:

      

       V = $13,800,000 + 22,500,000 + 1,440,000 = $37,740,000

       Next we need to find the cost of funds. We have the information available to calculate the cost of equity using the CAPM, so:

       RE = .05 + 1.3(.08) = .1540 or 15.40%

  The cost of debt is the YTM of the company’s outstanding bonds, so:

       P0 = $920 = $35(PVIFAR%,30) + $1,000(PVIFR%,30)

       R = 3.96%

       YTM = 3.96% × 2 = 7.92%

       And the aftertax cost of debt is:          

       RD = (1 – .35)(.0792) = .0515 or 5.15%

       The cost of preferred stock is:

       RP = $5/$72 = .0694 or 6.94%

       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 = –$6,500,000 – 15,000,000 – 900,000 = –$22,400,000

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 = [($22.5/$37.74)(.1540) + ($1.44/$37.74)(.0694) + ($13.8/$37.74)(.0515)] = .1133

               The company wants to use the subjective approach to this project because it is located overseas. The adjustment factor is 2 percent, so the required return on this project is:

               Project required return = .1133 + .02 = .1333

       c.     The annual depreciation for the equipment will be:

               $15,000,000/8 = $1,875,000

               So, the book value of the equipment at the end of five years will be:

               BV5 = $15,000,000 – 5($1,875,000) = $5,625,000

               So, the aftertax salvage value will be:

              

               Aftertax salvage value = $5,000,000 + .35($5,625,000 – 5,000,000) = $5,218,750

       d.     Using the tax shield approach, the OCF for this project is:

              

               OCF = [(P – v)Q – FC](1 – t) + tCD

               OCF = [($10,000 – 9,000)(12,000) – 400,000](1 – .35) + .35($15M/8) = $8,196,250

e.     The accounting breakeven sales figure for this project is:

                 QA = (FC + D)/(P – v) = ($400,000 + 1,875,000)/($10,000 – 9,000) = 2,275 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        –$22,400,000

                           1              8,196,250

                           2             8,196,250

                           3             8,196,250

                           4             8,196,250

                           5             18,815,000

               Using the required return of 13.33 percent, the NPV of the project is:

              

               NPV = –$22,400,000 + $8,196,250(PVIFA13.33%,4) + $18,815,000/1.13335

               NPV = $11,878,610.78

               And the IRR is:

               NPV = 0 = –$22,400,000 + $8,196,250(PVIFAIRR%,4) + $18,815,000/(1 + IRR)5

               IRR = 30.87%

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