Suppose you have been hired as a financial consultant to Defense Electronics, In
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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 $7.75 million after taxes. In five years, the land will be worth $8.05 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.6 million to build. The following market data on DEI’s securities are current:
46,500 6.8 percent coupon bonds outstanding, 20 years to maturity, selling for 93.5 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
DEI’s tax rate is 35 percent. The project requires $900,000 in initial net working capital investment to get operational.
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 $7.75 million after taxes. In five years, the land will be worth $8.05 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.6 million to build. The following market data on DEI’s securities are current:
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 +2 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).) Discount rateExplanation / Answer
Requirement 1:
Time 0 Cash flow: Cost of plant + Land Value + NWC
=> $13,600,000 + $7,750,000 + $900,000 = $22,250,000
Requirement 2:
Appropriate discount rate will be the current WACC + 2%. 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 = $935 (93.5% of $1,000)
C = $1,000 x 6.8% = $68
F = $1,000
YTM = the yield to maturity on the bond
t = 20
$935 = $68/2 {[1-(1+(YTM/2))-40/(YTM/2)] + [$1,000 / (1+ (YTM/2))40]
YTM = 7.43%
After tax YTM = 7.43% x (1-tax rate) => 7.43% x 0.65 = 4.8295%
Cost of equity: Rf + Beta*(Rm – Rf)
= 5.2% + 1.14*(7% - 5.2%) = 7.138%
Cost of preferred equity: 6.2%
Total Capital = (46,500 x $935) + (765,000 x $95.5) + (36,500 x $93.5) = $119,947,750
Weight of debt = (46,500 x $935)/ $119,947,750 = 0.36247033
Weight of equity = (765,000 x $95.5)/ $119,947,750 =0.60907770
Weight of preferred stock = (36,500 x $93.5)/ $119,947,750 = 0.02845197
WACC = (0.048295 x 0.017505504) + (0.07138 x 0.60907770) + (0.062 x 0.02845197) = 0.062745 or 6.2745%
Appropriate discount rate = 6.2745 + 2 = 8.2745%
Requirement 3:
Depreciation per year as per eight-year tax life = $13,600,000/8 = $1,700,000
Accumulated Depreciation at the end of 5 year = $1,710,000 x 5 = $8,500,000
Book Value of plant = $13,400,000 - $8,375,000 = $5,100,000
As salvage value is less than the asset’s book value, after tax salvage value will be the sold value.
Requirement 4:
Year
1
2
3
4
5
Sales
$172,550,000
$172,550,000
$172,550,000
$172,550,000
$172,550,000
Variable cost
$160,950,000
$160,950,000
$160,950,000
$160,950,000
$160,950,000
Fixed Cost
$2,450,000
$2,450,000
$2,450,000
$2,450,000
$2,450,000
Depreciation
$1,700,000
$1,700,000
$1,700,000
$1,700,000
$1,700,000
EBT
$7,450,000
$7,450,000
$7,450,000
$7,450,000
$7,450,000
Tax @ 35%
$2,607,500
$2,607,500
$2,607,500
$2,607,500
$2,607,500
Net Income
$4,842,500
$4,842,500
$4,842,500
$4,842,500
$4,842,500
Add: Depreciation
$1,700,000
$1,700,000
$1,700,000
$1,700,000
$1,700,000
Add: Recovery of NWC
$0
$0
$0
$0
$900,000
Add: Salvage Value of Plant
$0
$0
$0
$0
$1,650,000
Add: Recovery of Land worth with appreciated value
$0
$0
$0
$0
$8,050,000
OCF
$6,542,500
$6,542,500
$6,542,500
$6,542,500
$17,142,500
Requirement 5:
NPV = -$22,250,000 + [($6,542,500)/(1.082745)] + [($6,542,500)/(1.082745)2] + [($6,542,500)/(1.082745)3] + [($6,542,500)/(1.082745)4] + [($16,781,250)/(1.082745)5] = $10,807,598.68
IRR:
0 = = -$22,250,000 + [($6,542,500)/(1+IRR)] + [($6,542,500)/(1+IRR)2] + [($6,542,500)/(1+IRR)3] + [($6,542,500)/(1+IRR)4] + [($16,781,250)/(1+IRR)5] = 22.74%
Year
1
2
3
4
5
Sales
$172,550,000
$172,550,000
$172,550,000
$172,550,000
$172,550,000
Variable cost
$160,950,000
$160,950,000
$160,950,000
$160,950,000
$160,950,000
Fixed Cost
$2,450,000
$2,450,000
$2,450,000
$2,450,000
$2,450,000
Depreciation
$1,700,000
$1,700,000
$1,700,000
$1,700,000
$1,700,000
EBT
$7,450,000
$7,450,000
$7,450,000
$7,450,000
$7,450,000
Tax @ 35%
$2,607,500
$2,607,500
$2,607,500
$2,607,500
$2,607,500
Net Income
$4,842,500
$4,842,500
$4,842,500
$4,842,500
$4,842,500
Add: Depreciation
$1,700,000
$1,700,000
$1,700,000
$1,700,000
$1,700,000
Add: Recovery of NWC
$0
$0
$0
$0
$900,000
Add: Salvage Value of Plant
$0
$0
$0
$0
$1,650,000
Add: Recovery of Land worth with appreciated value
$0
$0
$0
$0
$8,050,000
OCF
$6,542,500
$6,542,500
$6,542,500
$6,542,500
$17,142,500
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