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 5-year project. The company bought some land three years ago for $7.3 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 $7.5 million. In five years, the aftertax value of the land will be $7.9 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 $55 million to build. The following market data on DEl's securities is

Risk

Debt:

130,000 6.1 percent coupon bonds outstanding, 25 years to matu-rity, selling for 104 percent of par; the bonds have a par value of $2.000 and make semiannual payments.

Common stock:

9,900,000 shares outstanding. selling for $68 per share; the beta is 1.20.

Preferred stock:

400,000 shares of 4.20 percent preferred stock outstanding, selling for $87 per share and having a par value of $100.

Market:

7 percent expected market risk premium; 3.1 percent risk-free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 6.5 percent on new common stock issues, 4.5 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. DEl's tax rate is 25 percent. The project requires $2.5 million in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally.

1. Calculate the project's initial Year 0 cash flow, taking into account all side effects.
2. The new RDS project is somewhat riskier than a tvpical project for DEI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +2 percent 01.041 / 459

Calculate the appro-

priate discount rate to use

c. The manufacturing plant has

straight-line deprecia-

tion. At the end of the proiect (i.e.. the end of Year 5). the plant and equipmentcan be scrapped for $8.9 million. What is the aftertax salvage value of this plant and equipment?

1. The company will incur $8.1 million in annual fixed costs. The plan is to manufacture 18,500 RDSs per year and sell them at $11,600 per machine; the variable production costs are $9,750 per RDS. What is the annual operating cash flow (OCF) from this project?
2. DEI's comptroller is primarily interested in the impact of DEl'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?
3. 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 (IRR) and net present value (NPV) are. What will you report?