Project Evaluation 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 wants to build its new manufacturing plant on some land that it owns; the plant will cost $14 million to build. The following market data on DEI’s securities are current:
Debt: 10,000 8 percent coupon bonds outstanding, 15 years to maturity, selling for 92 percent of par; the bonds have a $1000 par value each an make semiannual payments.
Common Stock: 250,000 shares outstanding, selling for $70 per share; the beta is 1.4.
Preferred Stock: 10,000 shares pf 6 percent preferred stock outstanding with a par value of $100 per share, selling for $95 per share.
Market: 8 percent expected market risk premium; 5 percent risk-free rate.
DEI’s tax rate is 35 percent. The project requires $900,000 in initial new working capital investment to get operational.
Calculate the project’s initial Time 0 cash flow.
The new RDS project is somewhat a riskier than 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 evaluation DEI’s project.
The manufacturing plant has an eight-year depreciation tax life, and DEI uses straight-line depreciation to zero. At the end of the project (i.e., the end of Year 5), the plant can be scrapped for $5 million. What is the after-tax salvage value of the manufacturing plant?
The company will incur $350,000 in annual fixed costs. The plan is to manufacture 10,000 RDSs per year and sell them at $10,400 per machine; the variable production costs are $8,500 per RDS. What is the annual operating cast flow, OCF, from this project?
Finally, DEI”s president wants you to throw all you 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. What will you report?
DEI’s president points out the company bought the land that the plant would be built on 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 $10 million. What would be your recommendation regarding the RDS plant project if the company could sell the land today for its appraised value of $10 million? Explain your recommendation.
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