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Suppose you have been hired as a financial consultant to Defense Electronics, Inc. (DEI), a large,...

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Finance

Suppose you have been hired as a financial consultant to DefenseElectronics, Inc. (DEI), a large, publicly traded firm that is themarket share leader in radar detection systems (RDSs). The companyis looking at setting up a manufacturing plant overseas to producea new line of RDSs. This will be a five-year project. The companybought some land three years ago for $2.9 million in anticipationof using it as a toxic dump site for waste chemicals, but it builta piping system to safely discard the chemicals instead. The landwas appraised last week for $6 million on an aftertax basis. Infive years, the aftertax value of the land will be $6.4 million,but the company expects to keep the land for a future project. Thecompany wants to build its new manufacturing plant on this land;the plant and equipment will cost $32.6 million to build. Thefollowing market data on DEI’s securities are current:

Debt: 245,000 bonds with a coupon rate of 6 percent outstanding,23 years to maturity, selling for 105 percent of par; the bondshave a $1,000 par value each and make semiannual payments.

Common stock: 9,500,000 shares outstanding, selling for $73.10per share; the beta is 1.2.

Preferred stock: 465,000 shares of 3.8 percent preferred stockoutstanding, selling for $83.00 per share. The par value is $100.Market: 6 percent expected market risk premium; 2.9 percentrisk-free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton chargesDEI spreads of 7 percent on new common stock issues, 4.5 percent onnew preferred stock issues, and 2.5 percent on new debt issues.Wharton has included all direct and indirect issuance costs (alongwith its profit) in setting these spreads. Wharton has recommendedto DEI that it raise the funds needed to build the plant by issuingnew shares of common stock. DEI’s tax rate is 22 percent. Theproject requires $1,475,000 in initial net working capitalinvestment to get operational. Assume DEI raises all equity for newprojects externally and that the NWC does not require floatationcosts..

a. Calculate the project’s initial Time 0 cash flow,taking into account all side effects. (A negative answershould be indicated by a minus sign. Do not round intermediatecalculations and enter your answer in dollars, not millions ofdollars, rounded to the nearest whole dollar amount, e.g.,1,234,567.)

b. The new RDS project is somewhat riskier than atypical project for DEI, primarily because the plant is beinglocated overseas. Management has told you to use an adjustmentfactor of +1.5 percent to account for this increased riskiness.Calculate the appropriate discount rate to use when evaluatingDEI’s project. (Do not round intermediate calculations andenter 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. Atthe end of the project (that is, the end of Year 5), the plant andequipment can be scrapped for $5.2 million. What is the aftertaxsalvage value of this plant and equipment? (Do not roundintermediate calculations and enter your answer in dollars, notmillions of dollars, rounded to the nearest whole dollar amount,e.g., 1,234,567.)

d. The company will incur $7,500,000 in annual fixedcosts. The plan is to manufacture 19,550 RDSs per year and sellthem at $11,070 per machine; the variable production costs are$9,700 per RDS. What is the annual operating cash flow (OCF) fromthis project? (Do not round intermediate calculations andenter your answer in dollars, not millions of dollars, rounded tothe nearest whole dollar amount, e.g., 1,234,567.)

e. DEI’s comptroller is primarily interested in theimpact of DEI’s investments on the bottom line of reportedaccounting statements. What will you tell her is the accountingbreak-even quantity of RDSs sold for this project? (Do notround intermediate calculations and round your answer to nearestwhole number, e.g., 32.)

f. Finally, DEI’s president wants you to throw all yourcalculations, assumptions, and everything else into the report forthe chief financial officer; all he wants to know is what the RDSproject’s internal rate of return (IRR) and net present value (NPV)are. (Do not round intermediate calculations. Enter yourNPV in dollars, not millions of dollars, rounded to 2 decimalplaces, e.g., 1,234,567.89. Enter your IRR as a percent rounded to2 decimal places, e.g., 32.16.)

Answer & Explanation Solved by verified expert
4.1 Ratings (499 Votes)
Part aThe value of initial time 0 cash flow is determined asbelowInitial Cash Flow at Time 0 Appraised Value of Land Costof Building Plant and Equipment Net Working CapitalSubstituting values in the above formula we getInitial Cash Flow at Time 0 6000000 32600000 1475000 40075000answer for Part aPart bStep 1Calculate Weights of Different Sources ofFinanceTo calculate the weight of different sources of finance we needto determine the market value of each form of finance as belowMarket Value of Debt Number of BondsPar ValueCurrent SellingPrice Percentage 2450001000105 257250000Market Value of Common Stock Number of SharesCurrent SellingPrice 95000007310 694450000Market Value of Preferred Stock Number of SharesCurrentSelling Price 46500083 38595000Total Market Value of Firm Market Value of Debt Market Valueof Common Stock Market Value of Preferred Stock 257250000    See Answer
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Suppose you have been hired as a financial consultant to DefenseElectronics, Inc. (DEI), a large, publicly traded firm that is themarket share leader in radar detection systems (RDSs). The companyis looking at setting up a manufacturing plant overseas to producea new line of RDSs. This will be a five-year project. The companybought some land three years ago for $2.9 million in anticipationof using it as a toxic dump site for waste chemicals, but it builta piping system to safely discard the chemicals instead. The landwas appraised last week for $6 million on an aftertax basis. Infive years, the aftertax value of the land will be $6.4 million,but the company expects to keep the land for a future project. Thecompany wants to build its new manufacturing plant on this land;the plant and equipment will cost $32.6 million to build. Thefollowing market data on DEI’s securities are current:Debt: 245,000 bonds with a coupon rate of 6 percent outstanding,23 years to maturity, selling for 105 percent of par; the bondshave a $1,000 par value each and make semiannual payments.Common stock: 9,500,000 shares outstanding, selling for $73.10per share; the beta is 1.2.Preferred stock: 465,000 shares of 3.8 percent preferred stockoutstanding, selling for $83.00 per share. The par value is $100.Market: 6 percent expected market risk premium; 2.9 percentrisk-free rate.DEI uses G.M. Wharton as its lead underwriter. Wharton chargesDEI spreads of 7 percent on new common stock issues, 4.5 percent onnew preferred stock issues, and 2.5 percent on new debt issues.Wharton has included all direct and indirect issuance costs (alongwith its profit) in setting these spreads. Wharton has recommendedto DEI that it raise the funds needed to build the plant by issuingnew shares of common stock. DEI’s tax rate is 22 percent. Theproject requires $1,475,000 in initial net working capitalinvestment to get operational. Assume DEI raises all equity for newprojects externally and that the NWC does not require floatationcosts..a. Calculate the project’s initial Time 0 cash flow,taking into account all side effects. (A negative answershould be indicated by a minus sign. Do not round intermediatecalculations and enter your answer in dollars, not millions ofdollars, rounded to the nearest whole dollar amount, e.g.,1,234,567.)b. The new RDS project is somewhat riskier than atypical project for DEI, primarily because the plant is beinglocated overseas. Management has told you to use an adjustmentfactor of +1.5 percent to account for this increased riskiness.Calculate the appropriate discount rate to use when evaluatingDEI’s project. (Do not round intermediate calculations andenter 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. Atthe end of the project (that is, the end of Year 5), the plant andequipment can be scrapped for $5.2 million. What is the aftertaxsalvage value of this plant and equipment? (Do not roundintermediate calculations and enter your answer in dollars, notmillions of dollars, rounded to the nearest whole dollar amount,e.g., 1,234,567.)d. The company will incur $7,500,000 in annual fixedcosts. The plan is to manufacture 19,550 RDSs per year and sellthem at $11,070 per machine; the variable production costs are$9,700 per RDS. What is the annual operating cash flow (OCF) fromthis project? (Do not round intermediate calculations andenter your answer in dollars, not millions of dollars, rounded tothe nearest whole dollar amount, e.g., 1,234,567.)e. DEI’s comptroller is primarily interested in theimpact of DEI’s investments on the bottom line of reportedaccounting statements. What will you tell her is the accountingbreak-even quantity of RDSs sold for this project? (Do notround intermediate calculations and round your answer to nearestwhole number, e.g., 32.)f. Finally, DEI’s president wants you to throw all yourcalculations, assumptions, and everything else into the report forthe chief financial officer; all he wants to know is what the RDSproject’s internal rate of return (IRR) and net present value (NPV)are. (Do not round intermediate calculations. Enter yourNPV in dollars, not millions of dollars, rounded to 2 decimalplaces, e.g., 1,234,567.89. Enter your IRR as a percent rounded to2 decimal places, e.g., 32.16.)

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