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Suppose you have been hired as a financial consultant to Defense Electronics, Inc. ( DEI ) , a large, publicly traded firm that is the
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 fiveyear project. The company bought some land three years ago for
$ 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 $ million. In five years, the aftertax value of
the land will be $ 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 $ million to build. The
following market data on DEIs securities is current:
Debt: units of percent coupon bonds outstanding,
years to maturity, selling for percent of par; the bonds
have a $ par value each and make semiannual
payments.
Common stock: shares outstanding, selling for $ per
share; the beta is
Preferred stock: shares of percent preferred stock outstanding,
selling for $ per share and having a par value of
$
Market data: percent expected market risk premium; percent
riskfree rate.
DEI uses GM Wharton as its lead underwriter. Wharton charges DEI spreads
of percent on new common stock issues, percent on new preferred stock
issues, and 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. DEIs tax rate is percent.
The project requires $ 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 projects initial Time cash flow, taking into account all
side effects. Assume that raising $ million through Wharton will
require flotation costs ie underwriting andor 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 percent to account for
this increased riskiness. Calculate the appropriate discount rate to use
when evaluating DEIs project.
c The manufacturing plant has an eightyear tax life, and DEI uses
straightline depreciation. At the end of the project that is the end of
Year the plant and equipment can be scrapped for $ million. What
is the aftertax salvage value of this plant and equipment?
d The company will incur $ in annual fixed costs. The plan is to
manufacture RDSs per year and sell them at $ per
machine; the variable production costs are $ per RDS What is
the annual operating cash flow OCF from this project?
e Finally, DEIs 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 projects internal rate of
return IRR and net present value NPV are. Assume that the net
working capital will not require flotation costs.
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