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Project Evaluation

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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 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 $6 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 $7.9 million. The company wants to build its new manufacturing plant on this land; the plant will cost $12.8 million to build. The following market data on DEI's securities are current:

Debt:
12,000 6 percent coupon bonds outstanding, 15 years to maturity, selling for 93 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock: 264,000 shares outstanding, selling for $76 per share; the beta is 1.2.

Preferred stock: 17,000 shares of 3.5 percent preferred stock outstanding, selling for $68 per share.

Market: 6.5 percent expected market risk premium; 3.5 percent risk-free rate.

DEI uses G. M. Wharton as its lead underwriter. Wharton charges DEI spreads of 7.5 percent on new common stock issues, 5.5 percent on new preferred stock issues, and 2.5 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 32 percent. The project requires $660,000 in initial net working capital investment to get operational. Note: Assume that the initial net working capital does not require floatation costs. Also note that the firm wishes to maintain a constant capital structure.

a. The project's initial Time 0 cash flow is $_________, taking into account all side effects. (Round answer to 2 decimal places.)

b. The new RDS 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. The appropriate discount rate to use when evaluating DEI's project is __________%. (Input answer as a percent rounded to 2 decimal places, without the percent sign.)

c. The manufacturing plant has a 8-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 $3.9 million. The aftertax salvage value of this manufacturing plant is $__________. (Round answer to nearest whole dollar.)

d. The company will incur $354,000 in annual fixed costs. The plan is to manufacture 9,000 RDSs per year and sell them at $8,000 per machine; the variable production costs are $7,000 per RDS. The annual operating cash flow, OCF, from this project is $__________. (Round answer to nearest whole dollar.)

e. DEI's comptroller is primarily interested in the impact of DEI's investments on the bottom line of reported accounting statements. The accounting break-even quantity of RDSs sold for this project is _______ units. (Round answer to 2 decimal places.)

f. Finally, DEI's president wants you to throw all of 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. You will report that the IRR is ________% (Input answer as a percent rounded to 2 decimal places, without the percent sign) and NPV is $______ (Round answer to 2 decimal places).

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a. The project's initial Time 0 cash flow is $_________, taking into account all side effects. (Round answer to 2 decimal places.)

The initial cash flow would be the initial working capital of $660,000. The cost to build the new plant $12.8 million. The land is currently owned by DEI, but if it builds the plant, it would lose the opportunity to sell that plant at its appraised value. We need to include this as the opportunity cost of land. Even otherwise, if the land was to be purchased, it would have to be at the current price. The project should account for the land cost. The cost is $7.9 million. The total cost is 0.66+12.8+7.9=$21.36 million.

b. The new RDS 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. The appropriate discount rate to use when evaluating DEI's project is __________%. (Input answer as a percent rounded to 2 decimal places, without the percent sign.)

For this we need the calculate the exisiting cost of capital. We will calculate the market value of debt, preferred stock, common stock and their respective cost to arrive at the cost of capital.
Cost of Debt - The debt ...

Solution Summary

The solution has the details of a capital budgeting project by DEI for the introduction of a new line of Radar Detection Systems

$2.19
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Attached you will find the PDF documents to some practice study problems that I am still trying to grasp and understand. These are the ones that I did not know how to do. Your help is greatly appreciated.

Chapter 8: practice problem 25 on PDF document page 234

Chapter 21: practice problem 8 on PDF document page 595

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