Problem 14-30 Project Evaluation [LO3, 4] Suppose you have been hired as a finan
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Question
Problem 14-30 Project Evaluation [LO3, 4]
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 $4.9 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 $5.7 million. In five years, the aftertax value of the land will be $6.1 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 $32.32 million to build. The following market data on DEI’s securities are current:
234,000 7.4 percent coupon bonds outstanding, 25 years to maturity, selling for 109 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
9,200,000 shares outstanding, selling for $71.40 per share; the beta is 1.2.
454,000 shares of 6 percent preferred stock outstanding, selling for $81.40 per share.
8 percent expected market risk premium; 6 percent risk-free rate.
DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 9 percent on new common stock issues, 7 percent on new preferred stock issues, and 5 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 38 percent. The project requires $1,400,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally and that the NWC does not require floatation costs..
Calculate the project’s initial Time 0 cash flow, taking into account all side effects. (Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32.)
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 +3 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
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 $4.9 million. What is the aftertax salvage value of this plant and equipment? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32.)
The company will incur $7,200,000 in annual fixed costs. The plan is to manufacture 19,000 RDSs per year and sell them at $11,000 per machine; the variable production costs are $9,600 per RDS. What is the annual operating cash flow (OCF) from this project? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32.)
DEI’s comptroller is primarily interested in the impact of DEI’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? (Do not round intermediate calculations and round your final answer to nearest whole number, e.g., 32.)
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. (Enter your NPV in dollars, not millions of dollars, e.g., 1,234,567. Enter your IRR as a percent. Do not round intermediate calculations and round your final answers to 2 decimal places, e.g., 32.16.)
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 $4.9 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 $5.7 million. In five years, the aftertax value of the land will be $6.1 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 $32.32 million to build. The following market data on DEI’s securities are current:
Explanation / Answer
1 Initial Investment - Cost of machine 32320000 Increase in Net Working capital - 1400000 33720000 2 WACC - (a) Cost of debt and market value Price of bond = PV of cash flows discounted at Yield 1000 x 109% = 1000 x 7.4% x 6/12 x (PVAF YTM, 25 x 2) + 1000 x PVIF (YTM, 25 x 2) 1090 = 37 x PVAF(YTM, 50) + 1000/(1+YTM)^50 Using linear interpolation - r= Price 3% 1180.11 r 1090.00 4% 935.55 r-3/4-3 = (1090 -1180.11)/(935.55-1090) r-3 = 0.3685 x 1 r = 3 + 0.3684 r = 3.3684 for 6 months 0r 6.7368 for year Post floatation cost = 6.7368/(1-0.05) = 7.0913684 Post tax KD = 7.0914 x (1-0.38)= 4.3966484 Market value of bond = 234000 x 1090= 255060000 (b) Value of stock and Ke Ke = Rf + (Rm-Rf) x B Ke = 6 + 8 x 1.2 = 15.6 Post flotation cost = 15.6/(1-0.09) 17.14285714 Market Value = 9200000 x 71.4 = 656880000 ( C) Value and cost of prefered stock - Kp = Dividend rate/(1-flotation cost) = (6/(1-0.07)) 6.4516129 Market value = 35900 x 92.9 3335110 Securities Weights Cost W X C (W) ( C) Debt 255060000 4.396648421 1121409146 Stock 656880000 17.14285714 11260800000 Prefered stock 3335110 6.451612903 21516838.71 915275110 12403725985 WACC = 12403725985/915275110 13.5519 Discount rate with risk premium = 13.5519+3 = 16.5519 3 Post tax salvage value - Salvage value at the end ofproject = 4900000 Book value 0f machine - Cost - 32320000 Less : Depreciation (cost x 5/8) 20200000 12120000 Loss on sale - -7220000 Tax savings - -2888000 Post tax salvage value - 7788000 4 Calculation of Annual operating cash flows Sales (19000 x 11000) 209000000 Less: Variable cost (9600 x 19000) 105600000 Contribution 103400000 Less: Fixed cost 7200000 Less: depreciation (cost/8) 4040000 Incremental EBIT 92160000 Less Tax @ 38% 35020800 PAT 57139200 Add: Depreciation 4040000 OCF 61179200 5 Accounting BEP = Fixed cost + Depreciation/(Selling price/unit -Variable cost/unit) 7200000+4040000/11000-9600 = 8028.571429 6 NPV - 0 1 to 4 5 Initial Investments -33720000 OCF 61179200 61179200 Post tax salvage value 7788000 Recovery of NWC 1400000 Net Cash flows -33720000 61179200 70367200 PV factors @ Discount rate 1 2.7676 0.4649465 PV of cash flows -33720000 169321497.7 32716986 NPV = 168318484.2 7 IRR - Using linear interpolation - r= NPV 180% 124342.68 r 0.00 181% -59821.06 r-180/181-180 = (0-124342.68)/(-59821.06-124342.68) r-180 = 0.6752 + 180 r = 180.68% Project is acceptable as it has a positive NPV and IRR more then WACC. Please provide feedback…. Thanks in advance…. :-)