Chapter 14 Comprehensive Problem

Project Evaluation

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 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 $6 million in anticipation of using it as a toxic dumps site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $4.25 million. The company wants to build its new manufacturing plant on this land; the plant will cost $7.2 million to build. The following market data on DEIs securities are current:

Debt: 10,000 8% coupon bonds outstanding, 15 years to maturity selling for 94% of par; the bonds have a $1,000 par value each and make semiannual payments.

Common Stock: 250,000 shares outstanding, selling for $65 per share; the beta is 1.3.

Preferred stock: 10,000 shares of 7% preferred stock outstanding, selling for $81 per share.

Market: 8% expected market risk premium; 5.65% risk-free rate

DEIs tax rate is 34%. The project requires $750,000 in initial net working capital investment to get operational.

a) Calculate the projects Time 0 cash flow, taking into account all side effects.

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 adjusted factor of +2% to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEIs project.

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 million. What is the after-tax salvage value of this manufacturing plant?

d) The company will incur $900,000 in annual fixed costs. The plan is to manufacture 10,000 RDSs per year and sell them at $10,000 per machine; the variable production costs are $9,100 per RDS. What is the annual operating cash flow, OCF, from this project?

e) Finally, DEIs president wants you to throw all your calculations, all your assumptions, and everything else into a report for the chief financial officer; all he wants to know is what the RDS projects internal rate of return, IRR, and net present value, NPV are. What will you report?