Question

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 $4.5 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 land were sold today, the net proceeds would be $5.5 million after taxes. In five years, the land will be worth $5.8 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $21.2 million to build. The following market data on DEI’s securities are current:

Debt:	60,000 6.2 percent coupon bonds outstanding, 25 years to maturity, selling for 98 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock:	1,350,000 shares outstanding, selling for $97 per share; the beta is 1.15.
Preferred stock:	90,000 shares of 5.7 percent preferred stock outstanding, par value of $100, selling for $95 per share.
Market:	7 percent expected market risk premium; 3.8 percent risk-free rate.

DEI’s tax rate is 25 percent. The project requires $825,000 in initial net working capital investment to get operational.

a.	Calculate the project’s Time 0 cash flow, taking into account all side effects. Assume that any NWC raised does not require floatation costs. (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 +2 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. At the end of the project (i.e., the end of year 5), the plant can be scrapped for $2.4 million. What is the aftertax salvage value of this manufacturing plant? (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 $3.6 million in annual fixed costs. The plan is to manufacture 13,500 RDSs per year and sell them at $10,800 per machine; the variable production costs are $9,900 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-1.	Calculate the net present value. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)
e-2.	Calculate the internal rate of return. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

1-	initial investment
	cost of machine		-21200000
	working capital		-825000
	total cash outflow		-22025000
2-	Discount rate
semiannual before tax cost of debt = Using rate function in MS excel	rate(nper,pmt,pv,fv,type) nper = 50 pmt = 31 pv = -980 fv =1000 type =0	RATE(50,31,-980,1000,0)	3.18%
annual after tax cost of debt	2*3.18*(1-.25)	4.77	4.77
cost of preferred stock	preferred dividend/market price	5.7/95	6.00%
cost of common stock = risk free rate+(market risk premium)*beta	3.8+(7)*1.15		11.85
WACC
source	value	weight	component ost	weight*component cost
debt	58800000	0.29584906	4.77	1.4112
preferred	9000000	0.04528302	6	0.27169811
common stock	130950000	0.65886792	11.85	7.80758491
total	198750000
WACC = sum of weight*component cost				9.49048302
Discount rate = WACC + additional premium	9.49+2			11.49
3-
Cost of machine		21200000
acumulated depreciation upto year 5 =(21200000/8)*5		21200000
book value of machine		0
sale value of machine		2400000
loss on sale of machine		0
after tax scrap value	2400000*(1-.25)	1800000
4-
Year	0	1	2	3	4	5
total cash outflow	-22025000
revenue= unit sold*selling price		145800000	145800000	145800000	145800000	145800000
variable production cost		133650000	133650000	133650000	133650000	133650000
fixed cost		3600000	3600000	3600000	3600000	3600000
annual depreciation =21200000/5		4240000	4240000	4240000	4240000	4240000
operating profit		4310000	4310000	4310000	4310000	4310000
less taxes -25%		1077500	1077500	1077500	1077500	1077500
after tax profit		3232500	3232500	3232500	3232500	3232500
add depreciation		4240000	4240000	4240000	4240000	4240000
recovery of working capital						825000
after tax scrap value						1800000
net operating cash flow	-22025000	7472500	7472500	7472500	7472500	10097500
5-
Year	0	1	2	3	4	5
net operating cash flow	-22025000	7472500	7472500	7472500	7472500	10097500
PVF at 11.49% =1/(1+r)^n	1	0.89694143	0.80450393	0.7215929	0.6472266	0.5805243
present value of operating cash flow	-22025000	6702394.83	6011655.6	5392102.97	4836400.5	5861844.4
NPV =sum of present value of cash flow	6779398.34
IRR =Using IRR function in MS excel	IRR(I3599:N3599)	22.70%

X New Microsoft Office Excel Worksheet Microsoft Excel Cia Formulas Data Home Insert Page Layout Review View Cut Σ AutoSum A A Wrap Text Calibri Percentage 11 E Copy Fill Соpy BIU EE E Merge & Center Conditional Format Formatting as Table Styles Sort & Find & Filter Select Editing Paste +.0 .00 Cell Insert Delete Format % .00.0 2Clear Format Painter Font Clipboard Alignment Number Styles Cells fox IRR(13599: N3599) J3603 F G J K L M 3583 4- 3584 Year 1 2 5 3585 total cash outflow -22025000 revenue unit sold selling price 145800000 1458000000 3586 145800000 145800000 145800000 variable production cost 3587 133650000 133650000 133650000 133650000 133650000 fixed cost 3588 3600000 3600000 3600000 3600000 3600000 annual depreciation -21200000/5 operating profit 3589 4240000 4240000 4240000 4240000 4240000 4310000 3590 4310000 4310000 4310000 4310000 less taxes -25% 3591 1077500 1077500 1077500 1077500 1077500 after tax profit 3592 3232500 3232500 3232500 3232500 3232500 3593 add depreciation 4240000 4240000 4240000 4240000 4240000 recovery of working capital after tax scrap value 3594 825000 3595 1800000 7472500 7472500 7472500 7472500 3596 net operating cash -22025000 10097500 3597 5- 3598 Year 1 2 3 4 net operating cash PVF at 11.49% -1/( present value of o 7472500 7472500 3599 -22025000 7472500 7472500 10097500 3600 1 0.89694143 0.80450393 0.7215929 0.6472266 0.5805243 3601 -22025000 6702394.83 6011655.6 5392102.97 4836400.5 5861844.4 NPV sum of prese 3602 6779398.34 IRR(13599:N3 22.70% IRR =Using IRR fund599) 3603 3604 3605 3606