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 $5.5 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. The land was appraised last week for $6.2 million. In five years, the after-tax
value of the land will be $7.5 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 $45.0 million to build. The following market data on DEI’s securities:
◼ Debt:
360,000 bonds with a coupon rate of 8.4 percent outstanding, 15 years to maturity, selling at
a premium of 4 percent of par; the bonds have a $1,000 par value each and make semiannual
payments.
◼ Common stock:
8,500,000 shares outstanding, selling for $70.0 per share; the beta is 1.15.
◼ Preferred stock:
900,000 shares of 6.25 percent preferred stock outstanding, selling for $72 per share; the
stock has a par value of $75.
◼ Market:
7.8 percent expected market risk premium; 4.2 percent risk-free rate.
DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 8 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 (along with its profit) in setting these
spreads. DEI’s tax rate is 21 percent. The project requires $6.0 million in initial net working capital
investment, which is also externally financed, to get operational.
1. Calculate the project’s initial Year 0 cash flow, taking into account all side effects.
2. 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 $8.5 million. What is the after-tax salvage value of this plant and equipment?
4. The company will incur $9.8 million in annual fixed costs. The plan is to manufacture
18,000 RDSs per year and sell them at $11,200 per machine; the variable production costs
are $10,000 per RDS. What is the annual operating cash flow (OCF) from this project?
5. Finally, DEI’s president wants you to throw all your calculations, assumptions, and
everything else into the report that includes the RDS project’s internal rate of return (IRR)
and net present value (NPV) are. What will you report?
Review Problem (Expanded) Answers for your reference –
V = B+S+P = $(374.4M + 595.0M + 64.8M) = $1,034.2M
1. fA = 5.9706%; CF0 = -$(45M+6M)/(1-.059706) + -$(6.2M-147K) = -$60,291,358
2. 10.255%
3. $[8.5M – 0.21*(8.5M-16.875M)] = $10,258,750
4. OCF = EBIT – Taxes + Depreciation = $(6,175,000 – 1,296,750 + 5,625,000) = $10,503,250
5. See #1 for CF0; #4 for CF1~4; CF5 = $34,262,000; ==> NPV=-$6,152,086; IRR=6.85%
Note: I strongly recommend you to create your own spreadsheet for this comprehensive review problem as a similar capital budgeting application will be on the midterm examination! If you prefer, you may adapt the posted Baldwin spreadsheet for part of your work on the review problem.
