helpQuestion $1(100\%)$

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 $$2\mathrm{.}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 appraised last week for $$3\mathrm{.}8$ million on an after$-$tax basis. In

five years, the after$-$tax value of the land will be $$4\mathrm{.}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 DEI's securities are current:

Debt: $,195,000$ bonds with a coupon rate of $6\mathrm{.}2$ percent outstanding, $25$ years to

maturity, selling for $106$ percent of par; the bonds have a $$1,000$ par value

each and make semi$-$annual payments.

Common stock: $8,100,000$ shares outstanding, selling for $$63$ per share; the beta is $1\mathrm{.}1.$

Preferred stock: $450,000$ shares of $4\mathrm{.}25$ percent preferred stock outstanding, selling for $$83$

per share.

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 raises the funds needed

to build the plant by issuing new shares of common stock. DEI's tax rate is $25$ percent. The

project requires $$1,500,000$ in initial net working capital investment to get operational.

Assume DEI raises all equity for new projects externally.

a$.$ Calculate the project's initial Time $0$ cash flow, considering all side effects. $(25$ marks$)$

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.