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 $7 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 $7.67 million after taxes. In five years, the land will be worth $7.97 million after taxes. The company wants to build its new manufacturing plant on this land, the plant will cost $13.28 million to build. The following market data on DEI's securities are current: Debt: 45,700 7 percent coupon bonds outstanding, 22 years to maturity, selling for 94.3 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Common stock: 757,000 shares outstanding, selling for $94.70 per share the beta is 1.27. Preferred stock: 35,700 shares of 6.3 percent preferred stock outstanding, selling for $92.70 per share. Market: 7.1 percent expected market risk premium; 5.3 percent risk-free rate. DEI's tax rate is 30 percent. The project requires $860,000 in initial networking capital investment to get operational. 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, e.g., 1,234,567.) Time 0 cash flow $ 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 +3 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.) Discount rate 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 $1.57 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, e.g., 1,234,567.) Aftertax salvage value $ The company will incur $2,370,000 in annual fixed costs. The plan is to manufacture 13,700 RDSs per year and sell them at $11,100 per machine; the variable production costs are $10,300 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, e.g., 1,234,567.) Operating cash flow Calculate the project's net present value. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Net present value $ Calculate the project's 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.) Internal rate of return %

Answer 1

a.

			Rationale
a	Cost of Plant	-13280000
	Net operating working capital	-860000
	Total	-14140000

b.

			Rationale
b	Beta	1.27
	Market Risk premium	7.10%
	Risk Free rate	5.30%
	Required rate	14.31700%	Required rate = Market risk premium*Beta + Risk Free rate
	Add: Increased riskiness	3%
	Rounded off figure	17.32%

c.

			Rationale
c	Cost of plant	13280000
	Annual Depreciation	1660000	Cost of plant / 8, since the machine has an 8 year tax life
	Depreciation for 5 years	8300000	Annual Depreciation * 5
	Value of Machine after 5 years	4980000	Cost of plan - depreciation for 5 years
	Scrap value	1570000	Given
	Capital Gain / Loss	-3410000	Scrap value - Value of machine after 5 years
	After tax Scrap value	1570000	There is no tax charged on capital losses

d.

			Rationale
d	Units produced annually	13700
	Price per unit	11100
	Variable costs	10300
	Contribution per unit	800	Price-variable cost per unit
	Total Contribution	10960000	Contribution per unit*units produced
	Fixed costs	2370000
	Operating cash flow	8590000	Total Contributions - Fixed costs

e. Formula for NPV:

where CF is the operating cash flow for a period
r = cost of capital
n = time period

NPV = CF/(1+r)"

			Rationale
e	NPV	1,31,41,453.71	NPV function used in Excel
	IRR	54%	IRR function used in Excel