Project Evaluation $[$G LO$3,4]$ 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 $$3\mathrm{.}9$ million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $$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 are 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 $$83$ per share, and a par value of $$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.

a$.$ Calculate the project's 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 DEI's project.

c$.$ The manufacturing plant has an eight$-$year tax life, and DEI uses straight$-$line depreciation to a zero salvage value. At the end of the project $($that is$,$ 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?

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 and net present value are. What will you report?