Suppose you have been hired as a financial consultant to Defense Electronics, In
ID: 2733310 • 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 $7.61 million after taxes. In five years, the land will be worth $7.91 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.04 million to build. The following market data on DEI’s securities are current:
Debt: 45,100 6.9 percent coupon bonds outstanding, 21 years to maturity, selling for 94.9 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock: 751,000 shares outstanding, selling for $94.10 per share; the beta is 1.21.
Preferred stock: 35,100 shares of 6.25 percent preferred stock outstanding, selling for $92.10 per share.
Market: 7.05 percent expected market risk premium; 5.25 percent risk-free rate.
DEI’s tax rate is 34 percent. The project requires $830,000 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).)
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 $1.51 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 $2,310,000 in annual fixed costs. The plan is to manufacture 13,100 RDSs per year and sell them at $10,500 per machine; the variable production costs are $9,700 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).)
(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).)
Explanation / Answer
1. Initial investment in the project can be calculated as follows
Since land is already in the company's balance sheet there is no cash flow for it. However in calculating the NPV of the project, present value of the land has to be considered as cash outflow.
Initial Investment = Land + Machine + Working Capital
Initial Investment = 7.61 + 13.04 + 0.83 = 21.48 million
Answer = 21,480,000
2. First calculate WACC of the company
Cost of debt can be calculated in excel as follows
=YIELD(A1,A2,6.9%,94.5,100,1) = 7.4%
Here A1 contains today's date and A2 contains maturity date which is 21 years from today
After tax cost of debt = 7.4% (1-34%) = 4.90%
Total debt = 45,100 * 1000 = 45,100,000
Cost of equity using CAPM is as follows
Cost of equity = 5.25% + 1.21 * 7.05% = 13.78%
Total Equity = 751000 * 94.10 = 70,669,100
Cost of preferred equity = 6.25%
Total Preferred equity = 35,100 * 92.10 = 3,232,710
Total Capital = 45,100,000 + 70,669,100 + 3,232,710 = 119,001,810
Debt Ratio = 0.38
Equity Ratio = 0.59
Preferred Equity Ratio = 0.03
WACC = 0.38 * 4.90% + 0.59 * 13.78% + 0.03 * 6.25% = 10.21%
Cost of project = 10.21% + 3.00% = 13.21%
3. Carrying value at the end of 5 years = ((8-5)/8) * 13.04 = 4.89 mn
It is sold for 1.51 mn, so there is loss in this sale. So company is going to get an after tax gain after the plant is sold
So after tax cash flow = 1.51 + (4.89 - 1.51) * 34% = $2.66 million
Answer = 2,660,000
4. OCF = (Revenue - Fixed Costs - variable Costs) * (1-Tax) + Dep * tax
OCF = (13100 * 10500 - 2310000 - 13100 * 9700) * 66% + 13.04/8 * 34%
OCF = 5,392,201
Please ask the remaining parts in another question.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.