Defense Electronics (DEI)

This is a comprehensive project evaluation problem bringing together much of what you have learned in this and previous chapters.

Format:

You must show your calculations. There is no specific written format required, but short verbal statements explaining your answers to each question are required.

The Case:

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 $4 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 company sold the land today, it would receive $5.1 million after taxes. In five years, the land can be sold for $6.0 million after taxes, but DEI intends 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 $35 million to build. The following market data on DEI's securities are current:

Debt: 240,000 7.5 percent coupon bonds outstanding, 20 years to maturity, selling for 94 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock: 9,000,000 shares outstanding, selling for $71 per share; the estimated beta is 1.2.

Preferred stock: 400,000 shares of 5.5 percent preferred stock outstanding, par value of $100 per share, selling for $81 per share.

Market: 8 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 equity (stock) issues, 6 percent on new preferred stock issues and 4 percent on new debt (bond) issues. Wharton has included all direct and indirect costs (along with its profit) in setting these spreads. In estimating DEIs WACC, you should assume that DEI retains their existing capital structure weights for debt, common stock and preferred stock in order to finance the project. DEI's tax rate is 35 percent. The project requires $1,300,000 in initial net working capital (NWC) investment to get operational. Assume Wharton raises all financing for the new project, to include the amount needed for NWC, externally.

a. Calculate the project's initial Time 0 cash flow, taking into account all side effects such as flotation costs. Floatation costs affect the amount of money that must be borrowed. That is, assume that the floatation costs will be paid with the funds (capital) raised. So, make sure you raise enough capital to pay for the project, to include NWC, and pay the floatation costs for each source of capital (equity, debt and preferred stock).

Note that the case tells you to assume that the firms current capital structure remains constant. As such, calculate the weighted average flotation cost. The weighted average flotation cost, fT, is the sum of the weight of each source of funds in the capital structure of the company times the flotation cost for each source. The cost of each source is given. You will need these same weights to calculate the firm's WACC.

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 adjustment factor of +2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI's project.

IMPORTANT: The sentence, "Wharton has recommended to DEI that is raise the funds needed to build the plant by issuing new shares of common stock" requires some extra thought. Your text tells you that 1) the WACC is normally the appropriate discount rate to use when valuing a project that is in the same risk class as the overall firm and 2) the cost of capital (the appropriate discount rate) depends on the risk of the project, not the source of the money.

In estimating an appropriate discount rate for the project, assume that DEI retains their existing capital structure weights for debt, common stock and preferred stock in order to finance the project. That is, assume that DEIs current capital structure is their target (optimal) capital structure. Note in the case, however, that management has determined that an adjustment factor of +2 percent must be used to account for the increased riskiness of the project relative to a typical project (project in the same risk class as the entire firm) for DEI. So, estimate DEIs WACC then add a 2% risk adjustment in order to arrive at an appropriate discount rate.