ch 14 7. value: 10.00 points Suppose you have been hired as a financial consulta

Question

ch 14

7.

value:
10.00 points

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 $4.0 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 $4.8 million. In five years, the aftertax value of the land will be $5.2 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 $31.60 million to build. The following market data on DEI’s securities are current:

225,000 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.

8,300,000 shares outstanding, selling for $70.50 per share; the beta is 1.1.

445,000 shares of 5 percent preferred stock outstanding, selling for $80.50 per share.

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 $1,175,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally and that the NWC does not require floatation costs..

Calculate the project’s initial time 0 cash flow, taking into account all side effects. (Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount.)

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 $4.0 million. What is the aftertax salvage value of this plant and equipment? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations.)

The company will incur $6,300,000 in annual fixed costs. The plan is to manufacture 14,500 RDSs per year and sell them at $10,550 per machine; the variable production costs are $9,150 per RDS. What is the annual operating cash flow (OCF) from this project? (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 and round your final answer to nearest whole number.)

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 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))

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 $4.0 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 $4.8 million. In five years, the aftertax value of the land will be $5.2 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 $31.60 million to build. The following market data on DEI’s securities are current:

Explanation / Answer

1 Initial Investment - Cost of machine 31600000 Increase in Net Working capital - 1175000 32775000 2 WACC - (a) Cost of debt and market value Price of bond = PV of cash flows discounted at Yield 1000 x 108% = 1000 x 7.2% x 6/12 x (PVAF YTM, 25 x 2) + 1000 x PVIF (YTM, 25 x 2) 1080 = 336 x PVAF(YTM, 50) + 1000/(1+YTM)^50 Using linear interpolation - r= Price 3% 1154.38 r 1080.00 4% 914.07 r-3/4-3 = (1080-1154.38)/(914-1154.38) r-3 = 0.3095 x 1 r = 3 + 0.3095 r = 3.3095 for 6 months 0r 6.619 for year Post floatation cost = 6.619/(1-0.04) = 6.8947917 Post tax KD = 6.8948 x (1-0.35)= 4.2747708 Market value of bond = 225000 x 1080 255060000 (b) Value of stock and Ke Ke = Rf + (Rm-Rf) x B Ke = 5 + 7 x 1.1 = 12.7 Post flotation cost = 12.7/(1-0.08) 13.80434783 Market Value = 8300000 x 70.5 585150000 ( C) Value and cost of prefered stock - Kp = Dividend rate/(1-flotation cost) = (5/(1-0.06)) 5.3191489 Market value = 445000 x 80.50 35822500 Securities Weights Cost W X C (W) ( C) Debt 255060000 4.274770833 1090323049 Stock 585150000 13.80434783 8077614130 Prefered stock 35822500 5.319148936 190545212.8 876032500 9358482392 WACC = 12403725985/915275110 10.6828 Discount rate with risk premium = 13.5519+3 = 13.6828 3 Post tax salvage value - Salvage value at the end ofproject = 4000000 Book value 0f machine - Cost - 31600000 Less : Depreciation (cost x 5/8) 19750000 11850000 Loss on sale - -7850000 Tax savings - -3140000 Post tax salvage value - 7140000 4 Calculation of Annual operating cash flows Sales 14500 x 10550 152975000 Less: Variable cost 14500 x 9150 132675000 Contribution 20300000 Less: Fixed cost 6300000 Less: depreciation (cost/8) 3950000 Incremental EBIT 10050000 Less Tax @ 35% 3517500 PAT 6532500 Add: Depreciation 3950000 OCF 10482500 5 Accounting BEP = Fixed cost + Depreciation/(Selling price/unit -Variable cost/unit) 6300000 + 3950000/10550-9150 = 7321.428571 6 NPV - 0 1 to 4 5 Initial Investments -32775000 OCF 10482500 10482500 Post tax salvage value 7140000 Recovery of NWC 1175000 Net Cash flows -32775000 10482500 18797500 PV factors @ Discount rate 1 2.9328 0.5266549 PV of cash flows -32775000 30742669.69 9899795.7 NPV = 7867465.398 7 IRR - Using linear interpolation - r= NPV 22% 319647.58 r 0.00 23% -434096.41 r-22/23-22 = (0-319647.58)/(-431096.41-319647.58) r-22 = 0.4241 x 1 r = 22.42% Project is acceptable as it has a positive NPV and IRR more then WACC. Please provide feedback…. Thanks in advance…. :-)

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