You were 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 $6 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 $1.30 million. The company wants to build its new manufacturing plant on this land; the plant will cost $6.5 million to build. The following market data on DEI's securities are current.
Debt 10,000 7-percent coupon bonds outstanding, 15 years to maturity, selling for 92 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common Stock 250,000 shares outstanding, selling for $55 per share; the beta is 1.4.
Preferred Stock 10,000 shares of 6 percent preferred stock outstanding, selling for $85 per share
Market 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 14 percent on new common stock issues, 9 percent on new preferred stock issues and 5 percent on new debt issues. 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 34 percent. The project requires $750,000 in initial net working capital investment to get operational.
a) Calculate the project's initial Time 0 cash flow.
b) Calculate the appropriate discount rate to use when evaluating DEI's project
c) The manufacturing plant has an eight-year tax life. At the end of the project (i.e. the end of Year 5), the plant can be scrapped for $2 million. What is the after-tax salvage value of this manufacturing plant?
d) The company will incur $200,000 in annual fixed costs. The plan is to manufacture 10,000 RDSs per year and selling them at $10,000 per machine; the variable production costs are $8,000 per RDS. What is the annual operating cash flow from this project?
e) What is the accounting break-even quantity of RDSs sold for this project?
f) What is the project's internal rate of return and net present value?