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 $5.4 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 $6.2 million. In five years, the aftertax value of the land will be $6.6 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 $32.72 million to build. The following market data on DEI’s securities is current:

239,000 7.2 percent coupon bonds outstanding, 25 years to maturity, selling for 108 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

9,700,000 shares outstanding, selling for $71.90 per share; the beta is 1.1.

459,000 shares of 5 percent preferred stock outstanding, selling for $81.90 per share and and having a par value of $100.

7 percent expected market risk premium; 5 percent risk-free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 8 percent on new common stock issues, 6 percent on new preferred stock issues, and 4 percent on new debt issues. Wharton has included all direct and indirect issuance costs (along with its profit) in setting these spreads. Wharton has recommended to DEI that it raise the funds needed to build the plant by issuing new shares of common stock. DEI’s tax rate is 35 percent. The project requires $1,525,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally.

Calculate the project’s initial Time 0 cash flow, taking into account all side effects. Assume that the net working capital will not require floatation costs. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

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 and round your final answer to 2 decimal places. (e.g., 32.16))

The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation. At the end of the project (that is, the end of year 5), the plant and equipment can be scrapped for $5.4 million. What is the aftertax salvage value of this plant and equipment? (Do not round intermediate calculations.Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

The company will incur $7,700,000 in annual fixed costs. The plan is to manufacture 21,500 RDSs per year and sell them at $11,250 per machine; the variable production costs are $9,850 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, i.e. 1,234,567.)

DEI’s comptroller is primarily interested in the impact of DEI’s investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of RDSs sold for this project? (Do not round intermediate calculations.)

Finally, DEI’s president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the RDS project’s internal rate of return (IRR) and net present value (NPV) are. (Enter your NPV answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

  Debt:

239,000 7.2 percent coupon bonds outstanding, 25 years to maturity, selling for 108 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

  Common stock:

9,700,000 shares outstanding, selling for $71.90 per share; the beta is 1.1.

  Preferred stock:

459,000 shares of 5 percent preferred stock outstanding, selling for $81.90 per share and and having a par value of $100.

Market:

7 percent expected market risk premium; 5 percent risk-free rate.

Explanation / Answer

59082406

The correct treatment of floatation cost is that it should be added to the project outflow, since it is a one time cost , non recurring in nature.

38.7825

The cost of land is not added since it is a sunk cost to the company.

B.WACC = (weight of debt * cost of debt + weight of preferred stock * cost of preff stock + weight of equity * cost of equity) + risk adjusted premium

Cost of debt

239000*1080 = 3.6% of 239000 * 1000 PVIFA ( r%, 50) + 239000000 PVIF(r%, 50)

r = 3.27% per semi annual = 6.54% per annum

Cost of preferred stock = dividend / market price = 100*5%/81.9 = 6.11%

Cost of equity = risk free rate +( market risk premium * beta) = 5 + (7*1.1) = 12.7%

14.17  

The depriciation charged on the land = 6.2/ 8 = 0.7750

The book value at the end of 5 years = 6.2 - (0.7750*5) = 2.3250

The sale price = 5.4 mn

The cost price = 2.3250

Balance = 3.0750

Tax @ 35% = 1.0763

So, after tax salvage value = 5.4 - 1.0763 = 4.3238mn

D.

Break even quantity = Fixed Cost / Contribution p.u

= 7700000 / 1400 = 5500 units

NPV = 17272500 PVIFA (14.17%,5) + 43238000 PVIF(14.17%,5) - 387825000

NPV = 222262470

IRR is PV of inflows = PV of outflows

  

17272500 PVIFA (r%,5) + 43238000 PVIF(r%,5) =387825000

r = 35.38%

Calculation of floatation cost No Total amount % of spreaad Amount of cost Equity 9700000 697430000 8% 55794400 Preferred Stock 459000 37592100 6% 2255526 Debt 239000 25812000 4% 1032480 Total

59082406

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