Chapter 13, Problem 24QP

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 10 produce a new tine of RDSs. This will be a five-year project. The company bought some land three years ago for $7 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 $7.1 million. In five years, the aftertax value of the land will be $7.4 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 $40 million 10 build. The following market data on DEI’s securities is current:

Debt:	260,000 6.8 percent coupon bonds outstanding, 25 years to maturity, selling for 103 percent of par; the bonds have a$1,000 par value each and make semiannual payments.
Common stock:	9,500,000 shares outstanding, selling for $67 per share; the beta is 1.25.
Preferred stock:	450,000 shares of 5.25 percent preferred stock outstanding, selling for $84 per share and having a par value of $100.
Market:	7 percent expected market risk premium; 3.6 percent risk-free rate.

DEI use G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 6.5 percent on new common stock issues, 4.5 percent on new preferred stock issues, and 3 percent on new debit 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 35 percent. The project requires $1,400,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally.

1. a. Calculate the project's initial Time 0 cash now, taking into account all side effects.
2. b. The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant i~ 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 evaluating DEI’s project.
3. c. 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 aftertax salvage value of this plant and equipment?
4. d. The company will incur $7,900,000 in annual fixed costs. The plan is to manufacture 18,000 RDSs per year and sell them at $10,900 per machine; the variable production costs are $9,450 per RDS. What is the annual operating cash now (OCF) from this project?
5. e. DEI’s comptroller is primarily interested in the impact of DEI’s investments on the bottom line of reported accounting Statement. What will you tell her is the accounting break-even quantity of ROSs sold for this project?
6. f. Finally, DEI’s president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer all he want he to know is what the RDS project’s internal rate of return (IRR) and net present value (NPV) are. What will you report?

Summary Introduction

To determine: The Initial Time 0 Cash Flow.

Introduction:

The cost of equity is the yield than an investor anticipates from the security as returns for the risk they accept by spend in the specific security. Additionally it is the return an investor needs before they prefer for an alternative investment which pays higher than the correct.

The cost of debt is the effective interest rate of cost which a business earns on their current debts. Debt involves in the formation of capital structure. As the debt is considered as an deduction expenditure, the cost of debt is usually determined as after-tax cost in order to formulate similar to the cost of equity.

Answer to Problem 24QP

The Initial Time 0 Cash Flow is -$50,794,407.64

Explanation of Solution

Determine the Value of Debt

$\begin{array}{c}ValueofDebt=\left[FaceValue\times BondsOuts\tan ding\times BondQuote\right]\\ =\left[\$1,000\times 260,000\times 103\%\right]\\ =\$267,800,000\end{array}$

Therefore the Value of Debt is $267,800,000

Determine the Value of Common Stock

$\begin{array}{c}ValueofCommonStock=\left[Share\mathrm{Pr}ice\times CommonStockOuts\mathrm{tanding}\right]\\ =\left[\$67\times 9,500,000\right]\\ =\$636,500,000\end{array}$

Therefore the Value of Common Stock is $636,500,000

Determine the Value of Preferred Stock

$\begin{array}{c}Valueof\mathrm{Pr}eferredStock=\left[Share\mathrm{Pr}ice\times \mathrm{Pr}eferredStockOuts\mathrm{tanding}\right]\\ =\left[\$84\times 450,000\right]\\ =\$37,800,000\end{array}$

Therefore the Value of Preferred Stock is $37,800,000

Determine the Total Market Value

$\begin{array}{c}TotalMarketValue=\left[\begin{array}{l}ValueofDebt+ValueofCommonStock+\\ Valueof\mathrm{Pr}eferredStock\end{array}\right]\\ =\left[\$267,800,000+\$636,500,000+\$37,800,000\right]\\ =\$942,100,000\end{array}$

Therefore the Total Market Value is $942,100,000

Determine the Weight of Debt

$\begin{array}{c}WeightofDebt=\left[\frac{ValueofDebt}{TotalMarketValue}\right]\\ =\left[\frac{\$267,800,000}{\$942,100,000}\right]\\ =0.28425or28.43\%\end{array}$

Therefore the Weight of Debt is 28.43%

Determine the Weight of Common Stock

$\begin{array}{c}WeightofCommonStock=\left[\frac{ValueofCommonStock}{TotalMarketValue}\right]\\ =\left[\frac{\$636,500,000}{\$942,100,000}\right]\\ =0.67561or67.56\%\end{array}$

Therefore the Weight of Common Stock is 67.56%

Determine the Weight of Preferred Stock

$\begin{array}{c}WeightofCommonStock=\left[\frac{Valueof\mathrm{Pr}eferredStock}{TotalMarketValue}\right]\\ =\left[\frac{\$37,800,000}{\$942,100,000}\right]\\ =0.04012or4.01\%\end{array}$

Therefore the Weight of Preferred Stock is 4.01%

Determine the Weighted Average Floatation Costs

$\begin{array}{c}FloatationCosts\left(f_T\right)=\left[\begin{array}{l}\left(Weigh{t}_{Debt}\times Rat{e}_{Debt}\right)+\left(Weigh{t}_{Equity}\times Rat{e}_{Equity}\right)+\\ \left(Weigh{t}_{\mathrm{Pr}eferred}\times Rat{e}_{\mathrm{Pr}eferred}\right)\end{array}\right]\\ =\left[\left(28.43\%\times 3\%\right)+\left(67.56\%\times 6.5\%\right)+\left(4.01\%\times 4.5\%\right)\right]\\ =\left[0.85\%+4.39\%+0.18\%\right]\\ =5.42\%\end{array}$

Therefore the Weighted Average Floatation Costs is 5.42%

Determine the Amount Raised

$\begin{array}{c}AmountRaised=\left[\frac{CostofNewPlant}{1-WeightedAverageFloatationCosts}\right]\\ =\left[\frac{\$40,000,000}{1-5.42\%}\right]\\ =\$42,294,407.64\end{array}$

Therefore the Amount Raised is $42,294,407.64

Determine the Initial Time 0 Cash Flow

$\begin{array}{c}InitialCashFlo{w}_{Year0}=\left[-AppraisedCostofLand-AmountRaised+InitialNWC\right]\\ =\left[-\$7,100,000-\$42,294,407.64+\$1,400,000\right]\\ =-\$50,794,407.64\end{array}$

Therefore the Initial Time 0 Cash Flow is -$50,794,407.64

Summary Introduction

To determine: The Discount Rate of the Project.

Answer to Problem 24QP

The Discount Rate of the Project is 11.81%

Explanation of Solution

Determine the Cost of Equity using CAPM

$\begin{array}{c}CostofEquity\left(R_e\right)=\left[\begin{array}{l}RiskfreeRate\left(R_f\right)+Beta\left(\beta \right)\times \\ MarketRisk\mathrm{Pr}emium\left(R_m\right)\end{array}\right]\\ =\left[3.6\%+1.25\times 7\%\right]\\ =\left[0.036+0.0875\right]\\ =0.1235or12.35\%\end{array}$

Therefore the Cost of Equity is 12.35%

Determine the After-tax Cost of Debt

Using excel function =rate we find the pre-tax and after-tax cost of debt as,

Excel Spreadsheet:

Therefore the After-tax Cost of Debt is 4.26%

Determine the Cost of Preferred Stock

$\begin{array}{c}CostofEquity\left(R_p\right)=\left[\frac{Valueof\mathrm{Pr}eferredStock}{\mathrm{Pr}icepershare}\right]\\ =\left[\frac{\left(\$100\times 5.25\%\right)}{\$84}\right]\\ =\left[\frac{\$5.25}{\$84}\right]\\ =0.0625or6.25\%\end{array}$

Therefore the Cost of Preferred Stock is 6.25%

Determine the WACC

$\begin{array}{c}WACC=\left[\left(Weigh{t}_d\times Rat{e}_d\right)+\left(Weigh{t}_e\times Rat{e}_e\right)+\left(Weigh{t}_p\times Rat{e}_p\right)\right]\\ =\left[\left(28.43\%\times 4.26\%\right)+\left(67.56\times 12.35\%\right)+\left(4.01\times 6.25\%\right)\right]\\ =\left[1.21\%+8.34\%+0.25\%\right]\\ =9.81\%\end{array}$

Therefore the WACC is 9.81%

Determine the Discount Rate of Project

$\begin{array}{c}DiscountRate=\left[WACC+AdjustmentFactor\right]\\ =\left[9.81\%+2\%\right]\\ =11.81\%\end{array}$

Therefore the Discount Rate of Project is 11.81%

Summary Introduction

To determine: The After-Tax Salvage Value.

Answer to Problem 24QP

The After-Tax Salvage Value is $10,775,000

Explanation of Solution

Determine the Annual Depreciation

$\begin{array}{c}AnnualDepreciation=\left[\frac{CostofMachinery}{Lifeof\mathrm{Pr}oject}\right]\\ =\left[\frac{\$40,000,000}{8}\right]\\ =\$5,000,000\end{array}$

Therefore the Annual Depreciation is $5,000,000

Determine the Book Value at the end of Year 5

$\begin{array}{c}BookValu{e}_{Year5}=\left[CostofMachinery-\left(Depreciation\times 5\right)\right]\\ =\left[\$40,000,000-\left(\$5,000,000\times 5\right)\right]\\ =\left[\$40,000,000-\$25,000,000\right]\\ =\$15,000,000\end{array}$

Therefore Book Value at the end of Year 5 is $15,000,000

Determine the After-Tax Salvage Value

$\begin{array}{c}AftertaxSalvageValue=\left[ScrapValue+\left(Tax\times \left(BookValue-ScrapValue\right)\right)\right]\\ =\left[\$8,500,000+\left(35\%\times \left(\$15,000,000-\$8,500,000\right)\right)\right]\\ =\left[\$8,500,000+\left(35\%\times \$6,500,000\right)\right]\\ =\left[\$8,500,000+\$2,275,000\right]\\ =\$10,775,000\end{array}$

Therefore After-Tax Salvage Value is $10,775,000

Summary Introduction

To determine: The Annual Operating Cash Flows.

Answer to Problem 24QP

The Annual Operating Cash Flows is $13,580,000

Explanation of Solution

Determine the Annual Operating Cash Flows

$\begin{array}{c}OCF=\left[\begin{array}{l}\left(\left(\mathrm{Pr}iceperunit-VariableCost\right)\times Units\right)-FixedCosts\times \\ \left(1-Tax\right)+\left(Depreciation\times Tax\right)\end{array}\right]\\ =\left[\begin{array}{l}\left(\left(\$10,900-\$9,450\right)\times 18,000\right)-\$7,900,000\times \left(1-35\%\right)+\\ \left(\$5,000,000\times 35\%\right)\end{array}\right]\\ =\left[\$11,830,000+1,750,000\right]\\ =\$13,580,000\end{array}$

Therefore the Annual Operating Cash Flows is $13,580,000

Summary Introduction

To determine: The Accounting Break-Even Sales Figure.

Answer to Problem 24QP

The Accounting Break-Even Sales Figure is 8,897 units

Explanation of Solution

Determine the Accounting Break Even Sales Figure

$\begin{array}{c}AccountingBreakEven=\left[\frac{\left(FixedCosts+Depreciation\right)}{\left(\mathrm{Pr}iceperunit-VariableCost\right)}\right]\\ =\left[\frac{\left(\$7,900,000+\$5,000,000\right)}{\left(\$10,900-\$9,450\right)}\right]\\ =\left[\frac{\$12,900,000}{1450}\right]\\ =8,896.551or8,897units\end{array}$

Therefore the Accounting Break Even Sales Figure is 8,897 units

Summary Introduction

To determine: The Net Present Value (NPV) and Internal Rate of Return (IRR).

Answer to Problem 24QP

The Net Present Value (NPV) is $9,591,825.14 and Internal Rate of Return (IRR) is 18.17%

Explanation of Solution

Determine the Net Present Value (NPV) and Internal Rate of Return

Using excel spreadsheet we calculate the Net Present Value (NPV) and Internal Rate of Return as,

Excel Spreadsheet:

Excel Workings:

Therefore the Net Present Value (NPV) is $9,591,825.14 and Internal Rate of Return (IRR) is 18.17%

Conclusion

Since the net present value (NPV) is positive the project should be accepted.