This is a comprehensive project evaluation problem bringing together much of what you have learned in this and previous chapters. 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 dumps 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 $4.8million, 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 will cost $37 million to build. The following market data on DEI’s securities are current:
Debt: 210,000 6.4% coupon bonds outstanding, 25 years to maturity selling for 108% 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 1.1.
Preferred stock: 450,000 shares of 4.5% preferred stock outstanding, selling for $81 per share.
Market: 7% expected market risk premium; 3.5% risk-free rate
DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 8% on new common stock issues, 6% on new preferred stock issues, and 4% on new debt issues. Wharton has included all direct and indirect issuance cost (along with 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 tax rate is 35%. The project requires $1,300,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new project externally.
a. Calculate the project’s Time 0 cash flow, taking into account all side effects.
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 adjusted factor of +2% to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project.
c. The manufacturing plant has an eight-year tax life, and DEI uses straight line depreciation. At the end of the project (i.e., the end of Year 5), the plant can be scrapped for $5.1 million. What is the after-tax salvage value of this manufacturing plant?
d. 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?
e. DEI comptroller is primarily interested in the impact of DEI’s investment on the bottom line of reported accounting statements. What will you tell her is the account break-even quantity of RDSs sold for this project?
f. Finally, DEI’s president wants you to throw all your calculations, all your assumptions, and everything else into a 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?