5. 30.

Project evaluation [LO 14.3, 14.4] This is a comprehensive project evaluation problem bringing together much of what you have learned in this and previous chapters. Suppose you have been hired as a financial consultant to Defence Electronics Limited (DEL), 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 $2.7 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. The land was valued last week for $3.8 million on an after-tax basis. In five years, the after-tax value of the land will be $4.1 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 $34 million to build. The following market data on DEL’s securities are current:

DEL uses G. M. Wharton as its lead underwriter. Wharton charges DEL spreads of 7 per cent on new ordinary share issues, 5 per cent on new preference share issues and 3 per cent 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 DEL that it raise the funds needed to build the plant by issuing new common shares. DEL’s tax rate is 30 per cent. The project requires $1 500 000 in initial net working capital investment to get operational. Assume DEL raises all equity for new projects externally.
1. Calculate the project’s initial Time 0 cash flow, taking into account all side effects.
2. The new RDS project is somewhat riskier than a typical project for DEL, primarily because the plant is being located overseas.
Management has told you to use an adjustment factor of +2 per cent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEL’s project.
3. The manufacturing plant has an eight-year tax life, and DEL uses straight-line depreciation to a zero salvage value. At the end of the project (that is, the end of Year 5), the plant and equipment can be scrapped for $4.9 million. What is the after-tax salvage value of this plant and equipment?

4. The company will incur $6.9 million in annual fixed costs. The plan is to manufacture 12 100 RDSs per year and sell them at $11 450 per machine; the variable production costs are $9500 per RDS. What is the annual operating cash flow (OCF) from this project?
5. DEL’s comptroller is primarily interested in the impact of DEL’s investments on the bottom line of reported accounting statements.
What will you tell her is the accounting break-even quantity of RDSs sold for this project?
6. Finally, DEL’s CEO wants you to throw all your calculations, assumptions and everything else into the report for the chief financial officer; all he wants to know is what the RDS project’s internal rate of return (IRR) and net present value (NPV) are.
What will you report?

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Debt: Ordinary shares: Preference shares: Market: 195000 bonds with a coupon rate of 6.2 per cent outstanding. 25 years to maturity, selling for 106 per cent of face value; the bonds have a $1000 face value each and make semiannual payments. 8100 000 shares outstanding, selling for $63 per share; the beta is 1.1. 450000 shares of 4.25 per cent preference shares outstanding. selling for $83 per share. 7 per cent expected market risk premium; 3.1 per cent risk- free rate.