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 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. If the company sold the land today, it would receive $5.1 million after taxes. In five years, the land can be sold for $6.0 million after taxes, but DEI intends to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant will cost $35 million to build. The following market data on DEI's securities are current:
Debt: 240,000 7.5 percent coupon bonds outstanding, 20 years to maturity, selling for 94 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock: 9,000,000 shares outstanding, selling for $71 per share; the estimated beta is 1.2.
Preferred stock: 400,000 shares of 5.5 percent preferred stock outstanding, par value of $100 per share, selling for $81 per share.
Market: 8 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 equity (stock) issues, 6 percent on new preferred stock issues and 4 percent on new debt (bond) issues. Wharton has included all direct and indirect costs (along with its profit) in setting these spreads. In estimating DEI’s WACC, you should assume that DEI retains their existing capital structure weights for debt, common stock and preferred stock in order to finance the project. DEI's tax rate is 35 percent. The project requires $1,300,000 in initial net working capital (NWC) investment to get operational. Assume Wharton raises all financing for the new project, to include the amount needed for NWC, externally.
a. Calculate the project's initial Time 0 cash flow, taking into account all side effects such as flotation costs. Floatation costs affect the amount of money that must be borrowed. That is, assume that the floatation costs will be paid with the funds (capital) raised. So, make sure you raise enough capital to pay for the project, to include NWC, and pay the floatation costs for each source of capital (equity, debt and preferred stock).
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 +2 percent (add 2 percent to your estimated WACC) 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 equipment can be sold for $6 million. Do not confuse the market value of the equipment with the market value of the land. What is the after-tax salvage value of the equipment?
d. The company will incur $7,000,000 in annual fixed costs. The plan is to manufacture 18,000 RDSs per year and sell them at $10,900 per machine; the variable production costs are $9,400 per RDS. What is the annual operating cash flow, OCF, from this project?
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 are both the Accounting and Financial Break-Even quantity of RDSs sold for this project? For an understanding of Accounting and Financial Break-Even (Break-Even Point), see EOC Questions 9.4 and 9.5 and Problems 9.1, 9.9, 9.10, 9.11 and 9.22. As your text states, “the break-even approach determines the sales needed to break even on the project investment – the point where the project generates no profits or loss.”
f. 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? Be sure to review the Baldwin case in Chapter 8 for how to handle the cash flow associated with the land. Note in the Baldwin case that the warehouse is an “opportunity cost” at t = 0, but becomes an “opportunity revenue” at the end of the projects life. Assume the same for the land in this case. Remember to recover any NWC cash outflows in the initial cash flow amount when the project ends.
g. What will be your estimate of NPV and IRR if the average RDS sales price per unit must be reduced by 5 percent (from $10,900 per unit to $10,355 per unit) in order to sell the 18,000 proposed units that are being manufactured? Will you still recommend the project?
h. What does a minor price adjustment like that suggest in g above tell you about the uncertainties involved in financial valuation? Discuss the importance of Scenario and Sensitivity Analysis in financial decision-making.