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 $4.5 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. If the land were sold today, the net proceeds would be $5 million

after taxes. In five years, the land will be worth $5.3 million after taxes.

The company wants to build its new manufacturing plant on this land; the

plant will cost $19.5 million to build. The following market data on DEI's

securities are current:

Debt: 60,000 6.2 percent coupon bonds outstanding,

25 years to maturity, selling for 95 percent of par; the

bonds have a $1,000 par value each and make

semiannual payments.

Common stock: 1,250,000 shares outstanding, selling for $97 per

share; the beta is 1.15.

Preferred stock: 90,000 shares of 5.8 percent preferred stock

outstanding, selling for $95 per share.

Market: 7 percent expected market risk premium; 3.8 percent

risk-free rate.

DEI's tax rate is 34 percent. The project requires $825,000 in initial net

working capital investment to get operational.

a. Calculate the project's 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. At the end of the project (i.e., the end of

Year 5), the plant can be scrapped for $2.1 million. What is the aftertax

salvage value of this manufacturing plant?