Suppose you have been hired as a financial consultant to Defense Electronics, In
ID: 2731370 • 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 $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 $7.7 million after taxes. In five years, the land will be worth $8 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.4 million to build. The following market data on DEI’s securities are current: Debt: 46,000 6.8 percent coupon bonds outstanding, 20 years to maturity, selling for 94.0 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Common stock: 760,000 shares outstanding, selling for $95.00 per share; the beta is 1.19. Preferred stock: 36,000 shares of 6.2 percent preferred stock outstanding, selling for $93.00 per share. Market: 7 percent expected market risk premium; 5.2 percent risk-free rate. DEI’s tax rate is 35 percent. The project requires $875,000 in initial net working capital investment to get operational.
Requirement 1: Calculate the project’s Time 0 cash flow, taking into account all side effects. Assume that any NWC raised does not require floatation costs. (Do not round intermediate calculations. Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).) Initial Time 0 cash flow $
Requirement 2: 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 +3 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 percentage rounded to 2 decimal places (e.g., 32.16).)
Requirement 3: The manufacturing plant has an eight-year tax life, and DEI uses straightline depreciation. At the end of the project (i.e., the end of year 5), the plant can be scrapped for $1.6 million. What is the aftertax salvage value of this manufacturing plant? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)
Requirement 4: The company will incur $2,400,000 in annual fixed costs. The plan is to manufacture 14,000 RDSs per year and sell them at $11,400 per machine; the variable production costs are $10,600 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 (e.g., 1,234,567).)
Requirement 5: (a) Calculate the net present value. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).) Net present value $ (b) Calculate the internal rate of return. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) Comment
Explanation / Answer
Requirement 1:
Time 0 Cash flow: Cost of plant + Land Value + NWC
=> $13,400,000 + $7,770,000 + $875,000 = $22,045,000
Requirement 2:
Appropriate discount rate will be the current WACC + 3%. So, first we need to calculate the WACC.
Cost of debt = After tax YTM of bond
Bond Value = C/2 {[1-(1+(YTM/2))-2t/(YTM/2)] + [F / (1+ (YTM/2))2t]
B0 = $940 (94% of $1,000)
C = $1,000 x 6.8% = $68
F = $1,000
YTM = the yield to maturity on the bond
t = 20
$940 = $68/2 {[1-(1+(YTM/2))-40/(YTM/2)] + [$1,000 / (1+ (YTM/2))40]
YTM = 7.38%
After tax YTM = 7.38% x (1-tax rate) => 7.38% x 0.65 = 4.797%
Cost of equity: Rf + Beta*(Rm – Rf)
= 5.2% + 1.19*(7% - 5.2%) = 7.442%
Cost of preferred equity: 6.2%
Total Capital = (46,000 x $940) + (760,000 x $95) + (36,000 x $93) = $118,788,000
Weight of debt = (46,000 x $940)/ $118,788,000 = 0.364009833
Weight of equity = (760,000 x $95)/ $118,788,000 =0.607805502
Weight of preferred stock = (36,000 x $93)/ $118,788,000 = 0.028184665
WACC = (0.04797 x 0.364009833) + (0.07442 x 0.607805502) + (0.062 x 0.028184665) = 0.064442 or 6.4442%
Appropriate discount rate = 6.4442 + 3 = 9.4442%
Requirement 3:
Depreciation per year as per eight-year tax life = $13,400,000/8 = $1,675,000
Accumulated Depreciation at the end of 5 year = $1,710,000 x 5 = $8,375,000
Book Value of plant = $13,400,000 - $8,375,000 = $5,025,000
As salvage value is less than the asset’s book value, after tax salvage value will be same.
Requirement 4:
Year
1
2
3
4
5
Sales
$159,600,000
$159,600,000
$159,600,000
$159,600,000
$159,600,000
Variable cost
$148,400,000
$148,400,000
$148,400,000
$148,400,000
$148,400,000
Fixed Cost
$2,400,000
$2,400,000
$2,400,000
$2,400,000
$2,400,000
Depreciation
$1,675,000
$1,675,000
$1,675,000
$1,675,000
$1,675,000
EBT
$7,125,000
$7,125,000
$7,125,000
$7,125,000
$7,125,000
Tax @ 35%
$2,493,750
$2,493,750
$2,493,750
$2,493,750
$2,493,750
Net Income
$4,631,250
$4,631,250
$4,631,250
$4,631,250
$4,631,250
Add: Depreciation
$1,675,000
$1,675,000
$1,675,000
$1,675,000
$1,675,000
Add: Recovery of NWC
$0
$0
$0
$0
$875,000
Add: Salvage Value of Plant
$0
$0
$0
$0
$1,600,000
Add: Recovery of Land Worth
$0
$0
$0
$0
$8,000,000
OCF
$6,306,250
$6,306,250
$6,306,250
$6,306,250
$16,781,250
Requirement 5:
NPV = -$22,045,000 + [($6,306,250)/(1.094442)] + [($6,306,250)/(1.094442)2] + [($6,306,250)/(1.094442)3] + [($6,306,250)/(1.094442)4] + [($16,781,250)/(1.094442)5] = $8,874,979.53
IRR:
0 = = -$22,045,000 + [($6,306,250)/(IRR)] + [($6,306,250)/(IRR)2] + [($6,306,250)/(IRR)3] + [($6,306,250)/(IRR)4] + [($16,781,250)/(IRR)5] = 21.80%
Year
1
2
3
4
5
Sales
$159,600,000
$159,600,000
$159,600,000
$159,600,000
$159,600,000
Variable cost
$148,400,000
$148,400,000
$148,400,000
$148,400,000
$148,400,000
Fixed Cost
$2,400,000
$2,400,000
$2,400,000
$2,400,000
$2,400,000
Depreciation
$1,675,000
$1,675,000
$1,675,000
$1,675,000
$1,675,000
EBT
$7,125,000
$7,125,000
$7,125,000
$7,125,000
$7,125,000
Tax @ 35%
$2,493,750
$2,493,750
$2,493,750
$2,493,750
$2,493,750
Net Income
$4,631,250
$4,631,250
$4,631,250
$4,631,250
$4,631,250
Add: Depreciation
$1,675,000
$1,675,000
$1,675,000
$1,675,000
$1,675,000
Add: Recovery of NWC
$0
$0
$0
$0
$875,000
Add: Salvage Value of Plant
$0
$0
$0
$0
$1,600,000
Add: Recovery of Land Worth
$0
$0
$0
$0
$8,000,000
OCF
$6,306,250
$6,306,250
$6,306,250
$6,306,250
$16,781,250
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