Financial Case Analysis

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 $$3\mathrm{.}9$ million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $$4\mathrm{.}1$ million on an aftertax basis. In five years, the aftertax value of the land will be $$4\mathrm{.}4$ million, but the company expects to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost $$37$ million to build. The following market data on DEI$$s securities is current:

Debt: $205,000$ bonds with a coupon rate of $5\mathrm{.}8$ percent outstanding, $25$ years to maturity, selling for $106$ percent of par; the bonds have a $$1,000$ par value each and make semiannual payments.

Common stock: $8,600,000$ shares outstanding, selling for $$67$ per share; the beta is $1\mathrm{.}15.$

Preferred stock: $500,000$ shares of $4$ percent preferred stock outstanding, selling for $$83$ per share; the stock has a par value of $$100.$

Market: $7$ percent expected market risk premium; $3\mathrm{.}1$ percent risk$-$free rate.

DEI uses G$.$M$.$ Wharton as its lead underwriter. Wharton charges DEI spreads of $7$ percent on new common stock issues, $5$ percent on new preferred stock issues, and $3$ 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. DEI$$s tax rate is $25$ percent. The project requires $$1\mathrm{.}5$ million in initial net working capital investment to get operational. Assume DEI raises all equity for new projects externally.

Before answering questions, calculate a few basic things:

a$.$ Estimate the MV of Common Stock $($ie Equity$),$ Preferred and Debt. Prices and their quantities are given. So now you have the proportion of equity, debt and preferred in the capital structure.

b$.$ Estimate the cost of equity $($using CAPM$),$ debt$($use RATE function in Excel to get the YTM$)$ and preferred $($annual dividend$/$price per share$)$

a$.$ Calculate the project$$s initial Year $0$ cash flow, taking into account all side effects. Assume that the net working capital will not require floatation costs.

$($Hint: First estimate the weighted avg. floatation cost $($floatation costs are also called $$spreads$$ in the case$)$ using the proportion of equity, debt and preferred as the weights. Then estimate the amount raised to finance the $$37$ million cost of equipment $-$ similar to shinedown example from Ch $13$ problems. This amount raised $+$ the land value in Year $0($this is the opportunity cost$)+$ initial working capital is the Year $0$ cash outflow.

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. $($Hint Estimate the WACC and add $2\%)$

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 and equipment can be scrapped for $$4\mathrm{.}9$ million. What is the aftertax salvage value of this plant and equipment?

d$.$ The company will incur $$6\mathrm{.}9$ million in annual fixed costs. The plan is to manufacture $8,500$ RDSs per year and sell them at $$13,450$ per machine; the variable production costs are $$10,600$ per RDS$.$ What is the annual operating cash flow $($OCF$)$ from this project? $($Hint: Similar to what was done in Chapter $6$ problems $$ calculate Sales, variable costs, fixed costs, depreciation etc to get the annual OCF$)$

e$.$ DEI$$s comptroller is primarily interested in the impact of DEI$$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?

f$.$ Finally, DEI$$s president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the RDS project$$s internal rate of return $($IRR$)$ and net present value $($NPV$)$ are.