Question

Pretend that 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 $3.9 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 $4.1 million on an after-tax basis. In five years, the after-tax value of the land will be $4.4 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 $37 million to build. The following market data on DEI's securities is current: debt: 205,000 bonds with a coupon rate of 5.8 percent outstanding, 25 years to maturity, selling for 106 percent of par; the bonds have a $1,000 par value each and make semiannual payments. 8,600,000 shares outstanding, selling for $67 per share; the beta is 1.15. 500,000 shares of 4 percent preferred stock outstanding, selling for $83 per share; the stock has a par value of $100. 7 percent expected market risk premium; 3.1 percent risk-free rate. DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 7 percent on new common stock issues, 5 percent on new preferred stock issues, and 3 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 $1.5 million in initial net working capital investment to get operational. Assume DEI raises all equity for new projects externally. 1. Calculate the project's initial year 0 cash flow, taking into account all side effects. Assume that the net working capital will not require flotation costs. 2. The new RDSS 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. 3. 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 and equipment can be scrapped for $4.9 million. What is the after-tax salvage value of this plant and equipment? 4. The company will incur $6.9 million in annual fixed costs. The plan is to manufacture 8,500 RDSS per year and sell them at $13,450 per machine; the variable production costs are $10,600 per RDS. What is the annual operating cash flow (OCF) from this project? 5. 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? 6. 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 RDSS project's internal rate of return (IRR) and net present value (NPV) are.

Answer 1

As a financial consultant, the calculation involves analyzing opportunity costs, accounting for tax implications, computing cash flows, and determining the IRR and NPV for an overseas plant project with various financial inputs and adjustments for risk.

Step-by-step explanation:

This complex question from a student involves financial calculations related to setting up a manufacturing plant overseas. To determine the initial year 0 cash flow, we must account for the cost of the land, not at its sunk cost, but its opportunity cost, the manufacturing plant and equipment, and the initial net working capital investment. To calculate the appropriate discount rate, we consider the company's cost of capital and adjust for additional risk. The after-tax salvage value of the plant is computed considering the tax implications of the sale. The annual operating cash flow (OCF) is determined through the difference between annual revenue and the sum of the fixed and variable costs. For the accounting break-even calculation, we need to cover the fixed costs and depreciation. The internal rate of return (IRR) and net present value (NPV) require all these inputs and are essential for evaluating the financial viability of the project.