Defense Electronics, Inc.

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 $$4$ million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $$4\mathrm{.}8$ million. In five years, the after$-$tax value of the land will be $$5\mathrm{.}2$ million, but the company expects to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost $$31\mathrm{.}6$ million to build. The following market data on DEIs securities is current:

Debt: $225,000$ units of $7\mathrm{.}2$ percent coupon bonds outstanding, $25$ years to maturity, selling for $108$ percent of par; the bonds have a $$1,000$ par value each and make semiannual payments.

Common stock: $8,300,000$ shares outstanding, selling for $$70\mathrm{.}50$ per share; the beta is $1\mathrm{.}1.$

Preferred stock: $445,000$ shares of $5$ percent preferred stock outstanding, selling for $$80\mathrm{.}50$ per share and having a par value of $$100.$

Market data: $7$ 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 stock issues, $6$ percent on new preferred stock issues, and $4$ percent 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 DEI that it raise the funds needed to build the plant by issuing new shares of common stock. DEIs tax rate is $25$ percent. The project requires $$1,175,000$ in initial net working capital investment to get operational. Assume Wharton raises funds for new projects externally using the same mix of firm capital structure.

Question

a$).$ Calculate the projects initial Time $0$ cash flow, taking into account all side effects. Assume that raising $$31\mathrm{.}6$ million through Wharton will require flotation costs $($i$.$e$.,$ underwriting and$/$or other fees$),$ but the net working capital will not require flotation costs.

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 DEIs project.

c$)$ The manufacturing plant has an eight$-$year tax life, and DEI uses straight$-$line depreciation. At the end of the project $($that is$,$ the end of Year $5),$ the plant and equipment can be scrapped for $$4$ million. What is the after$-$tax salvage value of this plant and equipment?

d$)$ The company will incur $$6,300,000$ in annual fixed costs. The plan is to manufacture $14,500$ RDSs per year and sell them at $$10,550$ per machine; the variable production costs are $$9,150$ per RDS$.$ What is the annual operating cash flow $($OCF$)$ from this project?

e$).$ Finally, DEIs president 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 projects internal rate of return $($IRR$)$ and net present value $($NPV$)$ are. Assume that the net working capital will not require flotation costs.