Question

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 5-year project. The company bought some land three years ago for $7.3 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 $7.5 million. In five years, the aftertax value of the land will be $7.9 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 $55 million to build. The following market data on DEI's securities is current: Debt: 130,000 6.1 percent coupon bonds outstanding, 25 years to maturity, selling for 104 percent of par; the bonds have a par value of $2,000 and make semiannual payments. Common stock: 9,900,000 shares outstanding, selling for $68 per share: the beta is 1.20. Preferred stock: 400,000 shares of 4.20 percent preferred stock outstanding, selling for $87 per share and having a par value of $100. Market: 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 6.5 percent on new common stock issues, 4.5 percent on new preferred stock issues, and 3 percent on new debt issues. Wharton has included all direct and indirect issuance costs

Answer 1

The $7.3 million cost of the land 3 years ago is a sunk cost and irrelevant; the $7.5 million appraised value of the land is an opportunity cost and is relevant. The $7.9 million land value in 5 years is a relevant cash flow as well. The fact that the company is keeping the land rather than selling it is unimportant. The land is an opportunity cost in 5 years and is a relevant cash flow for this project. The market value capitalization weights are:

B = 130,000($2,000)(1.04) = $270,400,000

S = 9,900,000($68) = $673,200,000

P = 400,000($87) = $34,800,000

The total market value of the company is:

V = $270,400,000 + 673,200,000 + 34,800,000 = $978,400,000

The weight of each form of financing in the company’s capital structure is:

XB = $270,400,000/$978,400,000 = .2764

XS = $673,200,000/$978,400,000 = .6881

XP= $34,800,000/$978,400,000 = .0356

Next we need to find the cost of funds. We have the information available to calculate the cost of equity using the CAPM, so:

RS = .031 + 1.20(.07)

RS= .1150, or 11.50%

The cost of debt is the YTM of the company’s outstanding bonds, so:

P0 = $2,080 = $61(PVIFAR%,50) + $2,000(PVIFR%,50)

R = 2.898%

YTM = 2.898% × 2 = 5.80%

And the aftertax cost of debt is:   

RB = (1 – .25)(.0580)

RB= .0435, or 4.35%

The cost of preferred stock is:

RP = $4.20/$87

RP= .0483, or 4.83%

a.   

The weighted average flotation cost is the sum of the weight of each source of funds in the capital structure of the company times the flotation costs, so:

fA = .6881(.065) + .2764(.03) + .0356(.045)

fA = .0546, or 5.46%

The initial cash outflow for the project needs to be adjusted for the flotation costs. To account for the flotation costs:

Amount raised(1 – .0546) = $55,000,000

Amount raised = $55,000,000/(1 – .0546)

Amount raised = $58,177,399

So the cash flow at time zero will be:

CF0 = –$7,500,000 – 58,177,399 – 2,500,000

CF0= –$68,177,399

There is an important caveat to this solution. This solution assumes that the increase in net working capital does not require the company to raise outside funds; therefore the flotation costs are not included. However, this is an assumption and the company could need to raise outside funds for the NWC. If this is true, the initial cash outlay includes these flotation costs, so:

Total cost of NWC including flotation costs:

$2,500,000/(1 – .0546) = $2,644,427

This would make the total initial cash flow:

CF0 = –$7,500,000 – 58,177,399 – 2,644,427

CF0= –$68,321,827

b.   

To find the required return on this project, we first need to calculate the WACC for the company. The company’s WACC is:

RWACC = .6881(.1150) + .2764(.0435) + .0356(.0483)]

RWACC= .0929, or 9.29%

The company wants to use the subjective approach to this project because it is located overseas. The adjustment factor is 2 percent, so the required return on this project is:

Project required return = 9.29% + 2%

Project required return = 11.29%

c.   

The annual depreciation for the equipment will be:

$55,000,000/8 = $6,875,000

So, the book value of the equipment at the end of five years will be:

BV5 = $55,000,000 – 5($6,875,000)

BV5= $20,625,000

So, the aftertax salvage value will be:

Aftertax salvage value = $8,900,000 + .25($20,625,000 – 8,900,000)

Aftertax salvage value = $11,831,250

d.   

Using the tax shield approach, the OCF for this project is:

OCF = [(P – v)Q – FC](1 – TC) + TCD

OCF = [($11,600 – 9,750)(18,500) – 8,100,000](1 – .25) + .25($55,000,000/8)

OCF = $21,312,500

e.   

The accounting break-even sales figure for this project is:

QA = (FC + D)/(P – v)

QA= ($8,100,000 + 6,875,000)/($11,600 – 9,750)

QA= 8,095 units

  

f.   

We have calculated all cash flows of the project. We need to make sure that in Year 5 we add back the aftertax salvage value and the recovery of the initial NWC. The cash flows for the project are:

Year   Flow Cash   

0 –$68,177,399

1 21,312,500

2 21,312,500

3 21,312,500

4 21,312,500

5 43,543,750

Using the required return of 11.29 percent, the NPV of the project is:

NPV = –$68,177,399 + $21,312,500(PVIFA11.29%,4) + $43,543,750/1.11295

NPV = $23,053,458

And the IRR is:

NPV = 0 = –$68,177,399 + $21,312,500(PVIFAIRR%,4) + $43,543,750/(1 + IRR)5

IRR = 22.67%

If the initial NWC is assumed to be financed from outside sources, the cash flows are:

Year   Flow Cash   

0 –$68,321,827

1 21,312,500

2 21,312,500

3 21,312,500

4 21,312,500

5 43,543,750

With this assumption, and the required return of 11.29 percent, the NPV of the project is:

NPV = –$68,321,827 + $21,312,500(PVIFA11.29%,4) + $43,543,750/1.11295

NPV = $22,909,030.76

And the IRR is:

IRR = 0 = –$68,321,827 + $21,312,500(PVIFAIRR%,4) + $43,543,750/(1 + IRR)5

IRR = 22.58%