This is a comprehensive projec
This is a comprehensive project evaluation problem bringingtogether much of what you have learned in this and previouschapters. Suppose you have been hired as a financial consultant toDefense Electronics, Inc. (DEI), a large, publicly traded firm thatis the market share leader in radar detection systems (RDSs). Thecompany is looking at setting up a manufacturing plant overseas toproduce a new line of RDSs. This will be a five-year project. Thecompany bought some land three years ago for $3.9 million inanticipation of using it as a toxic dump site for waste chemicals,but it built a piping system to safely discard the chemicalsinstead. The land was appraised last week for $4.4 million on anafter-tax basis. In five years, the after-tax value of the landwill be $4.8 million, but the company expects to keep the land fora future project. The company wants to build its new manufacturingplant on this land; the plant and equipment will cost $37 millionto build. The following market data on DEI’s securities arecurrent:
Debt: 210,000 6.4 percentcoupon bonds outstanding, 25 years to maturity, selling for 110percent of par; the bonds have a $1,000 par value each and makesemiannual payments.
Common stock: 8,300,000shares outstanding, selling for $68 per share; the beta is 1.3.
Preferred stock:450,000shares of 4.5 percent preferred stock outstanding, selling for $79per share.
Market: 6 percent expectedmarket risk premium; 3.5 percent risk-free rate.
DEI uses HSOB as its lead underwriter. Wharton charges DEIspreads of 10 percent on new common stock issues, 6 percent on newpreferred stock issues, and 4 percent on new debt issues. HSOB hasincluded all direct and indirect issuance costs (along with itsprofit) in setting these spreads. HSOB has recommended to DEI thatit raise the funds needed to build the plant by issuing new sharesof common stock. DEI’s tax rate is 32 percent. The project requires$1,300,000 in initial net working capital investment to getoperational. Assume DEI raises all equity for new projectsexternally.
Calculate the project’s initial Time 0 cash flow, taking intoaccount all side effects.
(This includes an adjustment for theflotation costs described in the above paragraph.The total costswill be the opportunity cost of the land, the cost of the buildingand the cost of the working capital.The cost of the building andworking capital will require new financing and therefore financecosts.Thus the building and working capital must be adjusted forthe flotation costs as discussed in section 14-7 of the11th edition and 14-6 of the 10th edition ofthe text.It is not necessary to adjust the land costs since wealready own the land.)
The new RDS project is somewhat riskier than a typical projectfor DEI, primarily because the plant is being located overseas.Management has told you to use an adjustment factor of +2 percentto account for this increased riskiness. Calculate the appropriatediscount rate to use when evaluating DEI’s project.
The manufacturing plant has aneight-year tax life, and DEI uses straight-line depreciation. Atthe end of the project (that is, the end of Year 5), the plant andequipment can be scrapped for $5.1 million. What is the after-taxsalvage value of this plant and equipment?
The company will incur $6,700,000 in annual fixed costs. Theplan is to manufacture 15,300 RDSs per year and sell them at$11,450 per machine; the variable production costs are $9,500 perRDS. What is the annual operating cash flow (OCF) from thisproject? Remember in year 5 that besides the cash flows fromoperation, you also get the salvage, tax benefit, land and theworking capital back. Note that while the WC outlay includes thefinancing costs, the amount back in time 5 will only be the WCamount. So the outlay for WC is 1,300,000 plus financing costs, butyou only recover the $1,300,000 since the financing costs have beenpaid out to your underwriter.
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. What will you report?
|Cost of Land||-$4,400,000|
|Cost of Plant(calculated below)||-$40,287,851.33|
|Cash flow at Time 0||-$45,987,851.33|
|Market Value(calculated below)||Weights||FloatationCost||Weighted flotationcost|
|Amount raised for cost of Plant =Amount raised (1-8.16%) = 37,000,000||$40,287,851.33|
|b. The new XYZ project is somewhatriskier than a typical project for ASE primarily because the plantis being located overseas. Management has told you to use anadjustment factor of 1 percent to account for this increasedriskiness. Calculate the appropriate discount rate to use whenevaluating AESI’s project.|
|Coupon Payment =1000 x 6.4%/2||$32|
|Nper = 25 x 2||50|
|Present Value =$1000 x 110%||1100|
|Semi Annual Costof Debt = YTM = Rate||2.82%|
|Annual Cost ofDebt after tax =2 x 2.82% x (1-32%)||3.84%|
|Market Value =210,000 x $1100||$231,000,000|
|Cost of Equity = Risk free rate +Beta x Market Risk Premium = 3.5% + 1.3 x 6%||11.30%|
|Market Value =8300000 shares x $68||$564,400,000|
|Cost of Preferred= Dividend/ Price = $100 x 4.5% / $79||5.70%|
|Market Value =450,000 shares x $79||$35,550,000|
|c) The manufacturing plant has aneight-year tax life, and DEI uses straight-line depreciation. Atthe end of the project (that is, the end of Year 5), the plant andequipment can be scrapped for $5.1 million. What is the after-taxsalvage value of this plant and equipment?|
|Annualdepreciation for the equipment = $37000000 /8||$4,625,000|
|Book value =$37000000 – (5 x 4,625,000)||$13,875,000|
|Aftertax salvage value = $5,100,000+ (32% x (13,875,000 – 5,100,000)||$7,908,000|
|d.The company will incur $6,700,000in annual fixed costs. The plan is to manufacture 15,300 RDSs peryear and sell them at $11,450 per machine; the variable productioncosts are $9,500 per RDS. What is the annual operating cash flow(OCF) from this project? What is the annual operating cash flow(OCF) from this project? (Enter your answer in dollars, notmillions of dollars, e.g., 1,234,567. Do not round intermediatecalculations and round your answer to the nearest whole number,e.g., 32.)|
|OCF = [(P – v)Q –FC](1 – t) + tCD|
|OCF = [($11,450 – 9,500)(15,300) –6,700,000](1 – .32) + .32($37M/8)||$17,211,800|
|e.ASE’s comptroller is primarilyinterested in the impact of ASE’s investments on the bottom line ofreported accounting statements. What will you tell her is theaccounting break-even quantity of XYZs sold for this project?|
|e. Accounting breakeven = QA = (FC+ D)/(P – v) = ($6,700,000 + 4,625,000)/($11,450 – 9,500)||$5,807.69||units|
|f.Finally, DEI’s president wantsyou to throw all your calculations, assumptions, and everythingelse into the report for the chief financial officer; all he wantsto know is what the RDS project’s internal rate of return (IRR) andnet present value (NPV) are.|
|Year||Cashflow||PV @10.99%||Present Value|
|Cashflow in 5th year = OCF + NWC +Residual value + aftertax value of the land|