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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 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 $4.8 million. In five years, the after-tax value of
the land will be $5.2 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 $31.6 million to build. The
following market data on DEIs securities is current:
Debt: 225,000 units of 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: 8,300,000 shares outstanding, selling for $70.50 per
share; the beta is 1.1.
1
Preferred stock: 445,000 shares of 5 percent preferred stock outstanding,
selling for $80.50 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. DEIs 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 projects initial Time 0 cash flow, taking into account all
side effects. Assume that raising $31.6 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 DEIs 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, 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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