Homework 6 PS4 Q8 Project Evaluation

(Complete the assignment in Excel. This is essentially a valuation problem where you need to figure out both cash flow and the discount rate. For examples of how to estimate cash flows refer back to HW4 and HW5 (LFPT case), the Norman Auto and Missouri Tennis mini-cases. For examples of how to calculate the discount rate, refer to the class slides, PS4 Q1-7, which we solved in class and which are in our class Excel file, and the e-book chapter 14.)

1. HOMEWORK-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 $4.5 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 $5.3 million. In five years, the aftertax value of the land will be $5.7 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 $32 million to build. The following market data on DEIs securities are current:

Debt: 230,000 7.2 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: 8,800,000 shares outstanding, selling for $71 per share; the beta is 1.1.

Preferred stock: 450,000 shares of 5 percent preferred stock outstanding, selling for $81 per share.

Note, as your book states in the chapter on stock valuation, preferred shares generally do not carry the voting rights (unlike common shares) and preferred shares have a stated liquidating value, usually $100 per share. The dividend yield is based on this $100 stated liquidating value.

Market: 7 percent expected market risk premium; 5 percent risk-free rate

DEIs tax rate is 35 percent. The project requires $1,300,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally.

a. Calculate the projects initial 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 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 $4.5 million. Use this to calculate the aftertax salvage value of this plant and equipment.

d. The company will incur $6,800,000 in annual fixed costs. The plan is to manufacture 17,000 RDSs per year and sell them at $10,800 per machine; the variable production costs are $9,400 per RDS. Use this to calculate the annual operating cash flow (OCF) from this project.

DEIs Chief Executive Officer (CEO) wants you to create a report for the Chief Financial Officer (CFO). Tell him:

1. What is the projects net present value (NPV)? Internal rate of return (IRR)?

Optional question to think about (NOT required for homework):

1. How would you plant costs change given the following information? Would NPV change?

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.

(Hint: The firm should use target weights even if it will finance the project with either debt or equity. The capital structure decision regarding debt-to-equity (D/E) ratios is made at a firm-wide level (and then maintained at the optimal D/E ratio)