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 $5.1 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 $5.9 million. In five years, the aftertax value of the land will be $6.3 million, 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 and equipment will cost $32.48 million to build. The following market data on DEI's securities are current: Debt: 236,000 7.2 percent coupon bonds outstanding, 25 years to maturity, selling for 108 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Common stock: 9,400,000 shares outstanding, selling for $71.60 per share; the beta is 1.1. Preferred stock: 456,000 shares of 5 percent preferred stock outstanding, selling for $81.60 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 8 percent on new common stock issues, 6 percent on new preferred stock issues, and 4 percent on new debt issues. Wharton has included all direct and indirect issuance costs (along with its 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. DЕl's tax rate is 35 percent. The project requires $1,450,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally and that the NWC does not require floatation costs..

Answer 1

a. Project's initial Time 0 cash flows:
Cost of plant & equipment	32480000
After-tax sale value lost on land(5900000*(1-35%))	3835000
Initial NWC	1450000
Intial time 0 cash flows	37765000

b.Weighted Average Cost of Capital --discount rate

After-tax cost of Bond

Using the formula, to find bond price,

Price=(Pmt.*(1-(1+YTM)^-n)/YTM)+(FV/(1+YTM)^n)

where,

Price=the curent market price less flotation costs,ie. 1000*1.08*(1-4%)= 1036.8

Pmt.=the semi-annual coupon amt.--ie. 1000*7.2%/2= 36

YTM=The reqd. semi-annual before-tax cost/ Yield ---to be found--??

n= no.of semi-annual coupon periods still to maturity--25 yrs. *2= 50

FV=Face value to be recd. At maturuty, ie. $ 1000

Plugging these values, in the formula,

1036.80=(36*(1-(1+YTM)^-50)/YTM)+(1000/(1+YTM)^50)

Solving the above , we get the before-tax semi-annual cost of the bond as

3.44%

so , the annual before tax cost=

(1+3.44%)^2-1=

7.00%

Now, the annual after-tax cost of the bond=

Annual Before-tax cost*(1-Tax Rate(

ie. 7%*(1-35%)=

4.55%

Cost of new common stock

as per CAPM,

Cost of equity, ke=RFR+U/w spread+(beta*MRP)

ie. 5%+8%+(1.1*7%)=

20.70%

Cost of Preferred stock

k ps=$ dividend/(net proceeds of the new issue)

ie.(100*5%)/(81.60*(1-6%))

6.52%

The WACC= (Wt.d*kd)+(Wt.e*ke)+(Wt.ps*kps)

Now we can claculate WACC by tabulating as follows:

Type of capital	Mkt. value	Wt. to total	Cost (as above)	Wt. *Cost
Debt	236000*1000*1.08=	254880000	26.41%	4.55%	1.20%
Common stock	9400000*71.60=	673040000	69.74%	20.70%	14.44%
Preferred stock	456000*81.60=	37209600	3.86%	6.52%	0.25%
Total		965129600	100.00%	WACC=	15.89%
			Add:Adj. factor	2%
			Discount rate to use	17.89%

c. After-tax salvage value:
Cost to build	32480000
Less:Acc. Depn. At end of yr. 5(32480000/8*5)	20300000
Carrying value at end Yr.5	12180000
Salvage at end yr. 5	5100000
Loss on salvage	7080000
Tax expense saved on loss at 35%*loss	2478000
ATCF on salvage(salvage+tax saved)	7578000
PLUS
ATCF on sale of land
(6300000*(1-35%)=	4095000
Total ATCF at end yr. 5	11673000

d.Annual operating cash flows:
Sale value (11100*20000)	222000000
Less: Variable cost(9700*20000)	-194000000
Less: Fixed costs	-7400000
Less: Deprecaition(32480000/8)	-4060000
EBT	16540000
Less: Tax at 35%	-5789000
EAT	10751000
Add back: Depn.	4060000
Annual OCF	14811000

e.Accounting break-even Qty.=(Fixed costs+depreciation)/(Selling price/unit-Variable costs/ unit)

ie.(7400000+4060000)/(11100-9700)=

8186

RDSs

f. IRR & NPV
Intial time 0 cash flows		37765000
Annual OCF		14811000
Total ATCF -salvage at end yr. 5	11673000
Initial NWC recovered at end Yr.5	1450000	13123000
Discount rate	17.89%
NPV=-37765000+(14811000*3.13498)+(13123000*0.43915)=
14430154
(P/A, i=17.89%, n=5)      3.13498
(P/F, i=17.89%,n=5)         0.43915
IRR=
0=-37765000+(14811000*(1-(1+r)^-5)/r))+(13123000/(1+r)^5)
solving for r, we get IRR= 32.32%