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 to produce a new line of RDSs. This will be a five-year project. The company bought some land three years ago for $4.5 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. If the land were sold today, the net proceeds would be $5 million after taxes. In five years, the land will be worth $5.3 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $15 million to build. The following market data on DEI's securities are current:
Debt: 40,000 6.2 percent coupon bonds outstanding, 25 years to maturity, selling for 95 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock: 825,000 shares outstanding, selling for $97 per share; the beta is 1.25.
Preferred stock: 45,000 shares of 5.8 percent preferred stock outstanding, selling for $95 per share.
Market: 7 percent expected market risk premium; 3.8 percent risk-free rate.
DEI's tax rate is 34 percent. The project requires $825,000 in initial net working capital investment to get operational.1. Calculate the appropriate discount rate to use when evaluating DEI's project. (40 points)
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