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 $7.2 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 $7.68 million after taxes. In five years, the land will be worth $7.98 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.32 million to build. The following market data on DEI’s securities are current:

Initial Cash Flow at Time 0 = -(Appraised Value of Land + Cost of Building Plant and Equipment + Net Working Capital)

Substituting values in the above formula, we get,

Initial Cash Flow at Time 0 = -(6,000,000 + 32,600,000 + 1,475,000) = -$40,075,000 (answer for Part a)

Part b)

Step 1: Calculate Weights of Different Sources of Finance

Market Value of Debt = Number of Bonds*Par Value*Current Selling Price Percentage = 245,000*1,000*105% = $257,250,000

Market Value of Common Stock = Number of Shares*Current Selling Price = 9,500,000*73.10 = $694,450,000

Market Value of Preferred Stock = Number of Shares*Current Selling Price = 465,000*83 = $38,595,000

Total Market Value of Firm = Market Value of Debt + Market Value of Common Stock + Market Value of Preferred Stock = 257,250,000 + 694,450,000 + 38,595,000 = $990,295,000

Now, we can calculate weights as follows:

Weight of Debt = Market Value of Debt/Total Market Value of Firm = 257,250,000/990,295,000

Weight of Equity = Market Value of Equity/Total Market Value of Firm = 694,450,000/990,295,000

Weight of Preferred Stock = Market Value of Preferred Stock/Total Market Value of Firm = 38,595,000/990,295,000

Step 2: Calculate After-Tax Cost of Debt

The after-tax cost of debt can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Payment (here, Coupon Payment), PV = Present Value (here, Current Selling Price) and FV = Future Value (here, Face Value of Bonds).

Here, Nper = 23*2 = 46, PMT = 1,000*6%*1/2 = $30, PV = 1,000*105% = $1,050 and FV = $1,000

Using these values in the above function/formula for Rate, we get,

Pre-Tax Cost of Debt = Rate(46,30,-1050,1000)*2 = 5.61%

After-Tax Cost of Debt = Pre-Tax Cost of Debt*(1-Tax Rate) = 5.61%*(1-22%) = 4.38%

Step 3: Calculate Cost of Preferred Stock

The cost of preferred stock is determined as below:

Cost of Preferred Stock = Annual Dividend/Current Stock Price*100 = (3.8%*100)/83*100 = 4.58%

Step 4: Calculate Cost of Equity

The cost of equity is arrived as below:

Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium) = 2.9% + 1.2*(6%) = 10.10%

Calculate Discount Rate

The value of discount rate is calculated as follows:

Discount Rate = (Weight of Debt*After-Tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Equity*Cost of Equity) + Appropriate Risk Adjustment Factor

Substituting values in the above formula, we get,

Discount Rate = (257,250,000/990,295,000*4.38% + 38,595,000/990,295,000*4.58% + 694, 450,000/990,295,000*10.10%) + 1.5% = 9.90% (answer for Part b)

The after-tax salvage value of the plant is arrived as below:

Annual Depreciation = Cost of Plant and Equipment/Useful Life = 32,600,000/8 = $4,075,000

Book Value of Plant and Equipment After 5 Years = Cost of Plant and Equipment - Annual Depreciation*5 = 32,600,000 - 4,075,000*5 = $12,225,000

Loss on Sale of Plant and Equipment = Book Value of Plant and Equipment After 5 Years - Salvage Value = 12,225,000 - 5,200,000 = $7,025,000

After-Tax Salvage Value = Salvage Value + Loss on Sale of Plant and Equipment*Tax Rate = 5,200,000 + 7,025,000*22% = $6,745,500 (answer for Part c)

The annual operating cash flow (OCF) is determined as follows:

Sales Value (19,550*11,070)216,418,500

Less Variable Costs (19,550*9,700)189,635,000

Fixed Costs7,500,000

Depreciation4,075,000

EBT15,208,500

Less Taxes3,345,870

EAT11,862,630

Add Depreciation4,075,000

Operating Cash Flow$15,937,630

Answer for Part d) is $15,937,630.

The accounting break-even quantity is calculated as follows:

Accounting Break-Even Quantity = (Fixed Cost + Depreciation)/(Selling Price - Variable Cost)

Substituting values in the above formula, we get,

Accounting Break-Even Quantity = (7,500,000 + 4,075,000)/(11,070 - 9,700) = 8,449 units (answer for Part e)

IRR

IRR is the minimum rate of return acceptable from a project. It can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The basic formula for calculating IRR is given below:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4 + Cash Flow Year 5/(1+IRR)^5

IRR is calculated with the use of EXCEL as below:

Year Cash Flow 0 -40075000 15937630 15937630 15937630 15937630 30558130 33.16% 4 6 4 IRR 10

where

IRR = RR(B2:B7) = 33.16%

NPV

The NPV can be calculated with the use of following formula:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Discount Rate)^1 + Cash Flow Year 2/(1+Discount Rate)^2 + Cash Flow Year 3/(1+Discount Rate)^3 + Cash Flow Year 4/(1+Discount Rate)^4 + Cash Flow Year 5/(1+Discount Rate)^5

Substituting values in the above formula, we get,

NPV = -40,075,000 + 15,937,630/(1+9.90%)^1 + 15,937,630/(1+9.90%)^2 + 15,937,630/(1+9.90%)^3 + 15,937,630/(1+9.90%)^4 + (15,937,630 + 6,745,500 + 1,475,000 + 6,400,000)/(1+9.90%)^5 = $29,619,521.66

answer; rapid growth in buyer demand and high buyer switching cost;