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$ 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{.}8$ million. In five years, the after$-$tax value of

the land will be $$5\mathrm{.}2$ 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 $$31\mathrm{.}6$ million to build. The

following market data on DEI$$s securities is current:

Debt: $225,000$ units of $7\mathrm{.}2$ 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: $8,300,000$ shares outstanding, selling for $$70\mathrm{.}50$ per

share; the beta is $1\mathrm{.}1.$

$1$

Preferred stock: $445,000$ shares of $5$ percent preferred stock outstanding,

selling for $$80\mathrm{.}50$ per share and having a par value of

$$100.$

Market data: $7$ percent expected market risk premium; $5$ percent

risk$-$free rate.

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. DEI$$s tax rate is $25$ percent.

The project requires $$1,175,000$ in initial net working capital investment to

get operational. Assume Wharton raises funds for new projects externally

using the same mix of firm capital structure.

a$.$ Calculate the project$$s initial Time $0$ cash flow, taking into account all

side effects. Assume that raising $$31\mathrm{.}6$ million through Wharton will

require flotation costs $($i$.$e$.,$ underwriting and$/$or other fees$),$ but the net

working capital will not require flotation costs.

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. At the end of the project $($that is$,$ the end of

Year $5),$ the plant and equipment can be scrapped for $$4$ million. What

is the after$-$tax salvage value of this plant and equipment?

d$.$ The company will incur $$6,300,000$ in annual fixed costs. The plan is to

manufacture $14,500$ RDSs per year and sell them at $$10,550$ per

machine; the variable production costs are $$9,150$ per RDS$.$ What is

the annual operating cash flow $($OCF$)$ from this project?

e$.$ 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. Assume that the net

working capital will not require flotation costs.