Question
I have been working on this problem for a bit, can someone work through the solutions so I can check my answers? Thanks! Project Evaluation:
I have been working on this problem for a bit, can someone work through the solutions so I can check my answers? Thanks!
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 (DET), 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 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 after tax value of the land will be $5.7 million, but the company expects to keep the land for 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 DEI's 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 5.0 percent preferred stock outstanding, selling for $81 per share
Market: 7 percent expected market risk premium: 5 percent risk-free rate.
DEI uses HSOB as its lead underwriter. HSOB charges DET spreads of 8 percent on new common stock issues, 6 percent on new preferred stock issues and 4 percent on new debt issues. HSOB included all direct and indirect issuance costs (along with its profit) in selling these spreads. HSOB has recommended to DEI that it raise the funds needed to build the plant by issuing new shares of common stock. DET's tax rate is 35 percent. The project requires $1,300,000 in initial net working capital investment to get operational. Assume HSOB raises all equity for new projects externally.
a.Calculate the project's initial time 0 cash flow, taking into account all side effects. (This includes an adjustment for the flotation costs described in the above paragraph.The total costs will be the opportunity cost of the land, the cost of the building and the cost of the working capital.The cost of the building and working capital will require new financing and therefore finance costs.Thus the building and working capital must be adjusted for the flotation costs as discussed on pages 472-473 of the text.It is not necessary to adjust the land costs since we already own the land.)
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 DEl's project. (WACC).
c.The manufacturing plant has an eight-year life, and DEI uses straight-line depreciation. At the end of the project (that is, the end of year 5), the plant and equipment call be scrapped for $4.5 million. What is the after tax salvage value of this plant and equipment? (Note the appropriate amount to depreciate is just the cost of the building of $32mm, NOT the cost of the building and the financing costs.Uncle Sam only allows depreciation on the actual cost.)
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. What is the annual operating cash flow (OCF) from this project? Remember in year 5 that besides the cash flows from operation, you also get the salvage, tax benefit and the working capital back. Note that while the WC outlay includes the financing costs, the amount back in time 5 will only be the WC amount. So the outlay for WC is 1,300,000 plus $95,299 of financing costs, but you only recover the $1,300,000 since the financing costs have been paid out to your underwriter.
e.IGNORE THIS PART
f.Finally, DEI's president wants you to throw all your calculation, 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)
Chapter 11 Question 12 Input area: Beta Market E(R) Risk-free return 1.02 12.00% 3.00% Output area: Stock E(R) 12.18% Chapter 12 Question 17 Input Area: Bond 1: Bonds outstanding Years to Maturity Annual coupon rate Coupons per year Bond price (% of par) 110,000 20 7.00% 2 109.50% Bond 2: Bonds outstanding Years to Maturity Annual coupon rate Coupons per year Bond price (% of par) 280,000 30 0.00% 2 18.00% Common stock Shares outstanding Beta Share price 3,100,000 1.10 $57.00 Preferred stock outstanding Shares outstanding Coupon rate Share price Market Market risk premium Risk-free rate Tax rate 200,000 5.00% $71.00 Period yield PMT Period yield RRR Par Value DV Amoun Yield 40 $35.00 60 13.80% 100 5 7.0% 8.00% 5.00% 25% Mark: Step 1: Calculate the market value of each component of the capital structure. Output Area: Market Value Capital Structure Mark: Step 2: Calculate the capital structure on a % basis. Bond 1 $ 120,450,000 33.30% Bond 2 Common stock Preferred stock Total firm $ $ $ $ 50,400,000 176,700,000 14,200,000 361,750,000 13.93% 48.85% 3.93% 100.00% culate the ue of each of the cture. 0.035 Mark: Step 2: Calculate the capital structure on a % basis. Cost Mark: Step 3: Use the provided information to calculate the cost of each component of the capital structure. Bond 1 before tax Bond 1 after tax Bond 2 before tax Bond 2 after tax Common Preferred WACC 6.17% 4.63% 5.80% 4.35% 13.80% 7.04% 9.16% Mark: Step 4: Calculate the weighted average cost of capital! Chapter 12 Question 24 Input Area: Land price Current land value Land value in 5 years Plant & Equipment cost $ $ $ $ Debt Bonds outstanding Years to Maturity Annual coupon rate Coupons per year Face value (% of par) Bond price (% of par) Common stock Shares outstanding Beta Share price 4,500,000 5,300,000 5,700,000 32,000,000 230,000 25 7.20% 2 1,000.00 108.00% $ 8,800,000 1.10 71.00 Preferred stock outstanding Shares outstanding Coupon rate Share price $ 450,000 5.00% 81.00 Market Market risk premium Risk-free rate Equity flotation cost Preferred flotation cost Debt flotation cost Tax rate Net working capital Does the NWC require flotation costs (Yes/No) 7.00% 5.00% $ 8.00% 4.00% 4.00% 35% 1,300,000 NO b. Adjustment factor c. Life of plant (years) Life of project (years) Plant salvage value d. Annual fixed costs # RDS manufactured Sale price per RDS Variable costs per RDS $ $ $ $ 2% 8 5 4,500,000 6,800,000 17,000 10,800 9,400 Output Area: Market value of debt Market value of equity Market value of preferred Market value of firm $ $ $ $ D/V E/V P/V 248,400,000 624,800,000 36,450,000 909,650,000 27.31% 68.69% 4.01% 100.00% a. flotation costs The cost of the land 3 years ago is a sunk cost and is irrelevant. Land $ 5,300,000 Plant & Equipment Cost 32,000,000 Net working capital 1,300,000 Total Time 0 $ 38,600,000 b. Pretax cost of debt Aftertax cost of debt Cost of equity Cost of preferred WACC 6.55% 4.25% 12.70% 6.17% 10.13% Discount rate for project c. Book value in year 5 Aftertax salvage value d. Sales Variable costs Fixed costs Depreciation EBIT Taxes Net income Depreciation Operating cash flow 12.13% Wd We Wp Total 27.31% 68.69% 4.01% 100.00% Mark: weighted average flotation costs. See section 12.11 in text book. Mark: See section 12.11. Gross up items, as appropriate, for flotation costs. Mark: = WACC + Adjustment for Risk Mark: $ 7,125,000 $ 183,600,000 159,800,000 6,800,000 4,000,000 13,000,000 4,550,000 8,450,000 4,000,000 12,450,000 $ $ $ Gross salvage value ((capital gain or loss) times (1-TR)) Mark: (fixed costs + depr) / (Sales price - variable cost) Mark: e. Accounting breakeven f. Year 0 1 2 3 4 5 IRR NPV 7,714 $ $ Cash Flow (38,600,000) 12,450,000 12,450,000 12,450,000 12,450,000 26,575,000 24.44% 14,100,557.72 (fixed costs + depr) / (Sales price - variable cost) Mark: = OCF + NWC + NSV + after-tax value of land value r loss) times depr) / variable WD V $ 12,000,000 Loss $ (7,500,000) TS $ (2,625,000) depr) / variable C + NSV + ue of landStep by Step Solution
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