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 $3.9 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 $4.4 million on an after-tax basis. In five years, the after-tax value of the land will be $4.8 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 $37 million to build. The following market data on DEI’s securities are current:

Debt: 210,000 6.4 percent coupon bonds outstanding, 25 years to maturity, selling for 110 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock: 8,300,000 shares outstanding, selling for $68 per share; the beta is 1.3.

Preferred stock:450,000 shares of 4.5 percent preferred stock outstanding, selling for $79 per share.

Market: 6 percent expected market risk premium; 3.5 percent risk-free rate.

DEI uses HSOB as its lead underwriter. Wharton charges DEI spreads of 10 percent on new common stock issues, 6 percent on new preferred stock issues, and 4 percent on new debt issues. HSOB has included all direct and indirect issuance costs (along with its profit) in setting these spreads. HSOB 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 32 percent. The project requires $1,300,000 in initial net working capital investment to get operational. Assume DEI raises all equity for new projects externally.

Part 1: Calculate the project’s initial Time 0 cash flow, taking into account all side effects.(This includes an adjustment for the flotation costs described in the above paragraph.The total costs will be the opportunity cost of the land, the cost of the building and the cost of the working capital.The cost of the building and working capital will require new financing and therefore finance costs. It is not necessary to adjust the land costs since we already own the land.)

Part 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.

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 $5.1 million. What is the after-tax salvage value of this plant and equipment? (Note the appropriate amount to depreciate is just the cost of the building of $37mm, NOT the cost of the building and the financing costs. Uncle Sam only allows depreciation on the actual cost.)

Part 3: The company will incur $6,700,000 in annual fixed costs. The plan is to manufacture 15,300 RDSs per year and sell them at $11,450 per machine; the variable production costs are $9,500 per RDS. What is the annual operating cash flow (OCF) from this project? Remember in year 5 that besides the cash flows from operation, you also get the salvage, tax benefit, land and the working capital back. Note that while the WC outlay includes the financing costs, the amount back in time 5 will only be the WC amount. So the outlay for WC is 1,300,000 plus financing costs, but you only recover the $1,300,000 since the financing costs have been paid out to your underwriter.

Part 4: 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. What will you report?

Explanation / Answer

Current value of the land = $44,00,000 Land value after 5 years = $48,00,000 Cost of new manufaturing plant = $ 3,70,00,000 Intial working capital = $ 13,00,000 Assume that company raising funds only through equity, SO cost of debt and cost of preference is not relevant for NPV calculation PART1: INTIAL CASH FLOW AT YEAR0: PARTICULARS AMOUNT ($) Opportunity cost of land             4,400,000 Cost of manufaturing of plant           37,000,000 Intial Working capital             1,300,000 Total Initial cash flow 42700000 PART 2: COMPUTATION OF DISCOUNT RATE Risk free return (Rf) 3.50% Risk premium (Rm-Rf) 6% Beta (b) 2 CAPM = Rf+ b(rm-rf) .= 3.5+2(6) Dicounting Factor = 15.50% PART 3: COMPUTATION OF OPERATING CASH FLOWS: Life of the project = 5 years Scrap value of the plant = 5100000 SLM depreciation= (37000000-5100000)/5 = 6380000 Tax rate = 32% Fixed costs per annum = 6700000 Expected sales per year = 15300 Selling price per unit = $11,450 Variable cost per unit = $9,500 PARTICULARS YEAR 1-5 Selling price per unit = $11,450 Variable cost per unit = $9,500 contribution per unit $1,950 number of units 15300 total contribution $29,835,000 fixed costs $6,700,000 Depreciation $6,380,000 PBIT $16,755,000 Less: Tax @ 32% $5,361,600 PAT $11,393,400 Add: Deprecaition $6,380,000 CFAT $17,773,400 PVAF @ 15.5 %, 5 years 3.3128 Present value of operating cash flows $58,879,719.52 PART4: NPV Computation of present value of terminal cash inflows:- PARTICULARS AMOUNT Working capital 1300000 Salavge value of plant 5100000 Total 6400000 Less: tax @ 32% 2048000 After tax inflows 4352000 After tax inflow in land 400000 total teminal cash inflows 4752000 PVF 15.5%, 5 Years 0.4865 present value of terminal cash inflows 2311848 Computation of NPV= NPV = Present value of operating cash inflows + persent value of terminal cash inflows - intial cash outflows .= 58879720+2311848-42700000 = 18491568 Since NPV is positive is better to start the project Computation of IRR YEAR PARTICULARS PVF @ 15.5% PVF @20% Amount PVF present value PVF present value 0 Intial outflows -42700000 1 -42700000 1 -42700000 1-5 Operating inflows 17773400 3.3128 58879719.5 2.991 53160239 5 Terminal inflows 4752000 0.4865 2311848 0.4019 1909828.8 18491567.5 12370068 IRR 15.5+ (18491567)/(18491567.5-12370068) * (20-15.5) 15.5+(3.020758 *4.5) 29.09%

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