Suppose you have been hired as a financial consultant to Defense Electronics, Incorporated (DEI), a large, publicly trad
Posted: Mon Nov 15, 2021 5:17 pm
Suppose you have been hired as a financial consultant to Defense
Electronics, Incorporated (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 $4.3 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 $6.7 million on an
aftertax basis. In five years, the aftertax value of the land will
be $7.8 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 $30.1 million
to build. The following market data on DEI’s securities are
current:
Debt: 170,000 bonds with a coupon rate of 7.4 percent
outstanding, 22 years to maturity, selling for 104 percent of par;
the bonds have a $2,000 par value each and make semiannual
payments.
Common stock: 10,900,000 shares outstanding, selling for $77.30
per share; the beta is 1.3.
Preferred stock: 535,000 shares of 5.2 percent preferred stock
outstanding, selling for $86.50 per share. The par value is
$100.
Market: 6.6 percent expected market risk premium; 4.3 percent
risk-free rate.
DEI uses G.M. Wharton as its lead underwriter. Wharton charges
DEI spreads of 6.5 percent on new common stock issues, 4 percent on
new preferred stock issues, and 2 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 21 percent. The
project requires $1,825,000 in initial net working capital
investment to get operational. Assume DEI raises all equity for new
projects externally and that the NWC does not require floatation
costs..
a. Calculate the project’s initial Time 0 cash flow, taking into
account all side effects. (A negative answer should be indicated by
a minus sign. Do not round intermediate calculations and enter your
answer in dollars, not millions of dollars, rounded to the nearest
whole number, e.g., 1,234,567.)
b. 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
+1.0 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 enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)
c. The manufacturing plant has an eight-year tax life, and DEI
uses straight-line depreciation to a zero salvage value. At the end
of the project (that is, the end of Year 5), the plant and
equipment can be scrapped for $6.6 million. What is the aftertax
salvage value of this plant and equipment? (Do not round
intermediate calculations and enter your answer in dollars, not
millions of dollars, rounded to the nearest whole number, e.g.,
1,234,567.)
d. The company will incur $8,900,000 in annual fixed costs. The
plan is to manufacture 19,900 RDSs per year and sell them at
$11,210 per machine; the variable production costs are $10,050 per
RDS. What is the annual operating cash flow (OCF) from this
project? (Do not round intermediate calculations and enter your
answer in dollars, not millions of dollars, rounded to the nearest
whole number, e.g., 1,234,567.)
e. 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 answer to nearest whole number, e.g.,
32.)
f. 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. (Do not round intermediate calculations. Enter your NPV in
dollars, not millions of dollars, rounded to 2 decimal places,
e.g., 1,234,567.89. Enter your IRR as a percent rounded to 2
decimal places, e.g., 32.16.)
Electronics, Incorporated (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 $4.3 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 $6.7 million on an
aftertax basis. In five years, the aftertax value of the land will
be $7.8 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 $30.1 million
to build. The following market data on DEI’s securities are
current:
Debt: 170,000 bonds with a coupon rate of 7.4 percent
outstanding, 22 years to maturity, selling for 104 percent of par;
the bonds have a $2,000 par value each and make semiannual
payments.
Common stock: 10,900,000 shares outstanding, selling for $77.30
per share; the beta is 1.3.
Preferred stock: 535,000 shares of 5.2 percent preferred stock
outstanding, selling for $86.50 per share. The par value is
$100.
Market: 6.6 percent expected market risk premium; 4.3 percent
risk-free rate.
DEI uses G.M. Wharton as its lead underwriter. Wharton charges
DEI spreads of 6.5 percent on new common stock issues, 4 percent on
new preferred stock issues, and 2 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 21 percent. The
project requires $1,825,000 in initial net working capital
investment to get operational. Assume DEI raises all equity for new
projects externally and that the NWC does not require floatation
costs..
a. Calculate the project’s initial Time 0 cash flow, taking into
account all side effects. (A negative answer should be indicated by
a minus sign. Do not round intermediate calculations and enter your
answer in dollars, not millions of dollars, rounded to the nearest
whole number, e.g., 1,234,567.)
b. 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
+1.0 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 enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)
c. The manufacturing plant has an eight-year tax life, and DEI
uses straight-line depreciation to a zero salvage value. At the end
of the project (that is, the end of Year 5), the plant and
equipment can be scrapped for $6.6 million. What is the aftertax
salvage value of this plant and equipment? (Do not round
intermediate calculations and enter your answer in dollars, not
millions of dollars, rounded to the nearest whole number, e.g.,
1,234,567.)
d. The company will incur $8,900,000 in annual fixed costs. The
plan is to manufacture 19,900 RDSs per year and sell them at
$11,210 per machine; the variable production costs are $10,050 per
RDS. What is the annual operating cash flow (OCF) from this
project? (Do not round intermediate calculations and enter your
answer in dollars, not millions of dollars, rounded to the nearest
whole number, e.g., 1,234,567.)
e. 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 answer to nearest whole number, e.g.,
32.)
f. 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. (Do not round intermediate calculations. Enter your NPV in
dollars, not millions of dollars, rounded to 2 decimal places,
e.g., 1,234,567.89. Enter your IRR as a percent rounded to 2
decimal places, e.g., 32.16.)