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