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 $4.2 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. The land was appraised last week for $5.0 million. In five years, the aftertax value of the land will be $5.4 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 $31.76 million to build. The following market data on DEI’s securities are current:
Debt:
227,000 7.4 percent coupon bonds outstanding, 25 years to maturity, selling for 109 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 $70.70 per share; the beta is 1.2.
Preferred stock:
447,000 shares of 6 percent preferred stock outstanding, selling for $80.70 per share.
Market:
8 percent expected market risk premium; 6 percent risk-free rate.
DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 9 percent on new common stock issues, 7 percent on new preferred stock issues, and 5 percent on new debt 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 38 percent. The project requires $1,225,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally and that the NWC does not require floatation costs..
A. Calculate the project’s initial time 0 cash flow, taking into account all side effects. (Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount.)
B. The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of 3 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
I'm not logged in but I really need help and it is due Tuesday. My YTM keeps getting a negative answer even though my professor says it has to be positive...
And for part A, I know you have to subtract, but I'm not sure which numbers.
I did both of these problems like more than 5x now.... Please help!!!!
dsmf v
A. To calculate the project's initial time 0 cash flow, we need to consider all side effects. Here's how you can do it step by step:
1. Calculate the cash inflow from selling the land:
Land value after 5 years = $5.4 million
Tax rate = 38%
After-tax cash inflow from selling the land = Land value after 5 years * (1 - Tax rate)
= $5.4 million * (1 - 0.38)
= $5.4 million * 0.62
= $3.348 million
2. Calculate the cash outflow for building the manufacturing plant:
Cost of plant and equipment = $31.76 million
Tax rate = 38%
After-tax cash outflow for building the manufacturing plant = Cost of plant and equipment * (1 - Tax rate)
= $31.76 million * (1 - 0.38)
= $31.76 million * 0.62
= $19.693 million
3. Calculate the net working capital investment:
Net working capital investment = $1,225,000
4. Calculate the issuance cost for new common stock:
Number of new common shares needed = Cash outflow for building the manufacturing plant / Price per share of common stock
= $19.693 million / $70.70 per share
= 278,333 shares (rounded to the nearest whole number)
Issuance cost for new common stock = Number of new common shares * Spread for new common stock issues
= 278,333 shares * 9% (0.09)
= $25,050
5. Calculate the initial time 0 cash flow:
Initial time 0 cash flow = After-tax cash inflow from selling the land - After-tax cash outflow for building the manufacturing plant - Net working capital investment - Issuance cost for new common stock
= $3.348 million - $19.693 million - $1,225,000 - $25,050
= -$17.02 million (rounded to the nearest whole dollar amount) (negative amount indicated by a minus sign)
Therefore, the project's initial time 0 cash flow, taking into account all side effects, is approximately -$17.02 million.
B. To calculate the appropriate discount rate to use when evaluating DEI's project, considering the increased riskiness due to being located overseas, you can follow these steps:
1. Start with the risk-free rate:
Risk-free rate = 6%
2. Calculate the market risk premium:
Market risk premium = 8%
3. Calculate the project's adjusted discount rate:
Adjustment factor for increased riskiness = 3%
Adjusted discount rate = Risk-free rate + (Beta * Market risk premium) + Adjustment factor for increased riskiness
= 6% + (1.2 * 8%) + 3%
= 6% + 9.6% + 3%
= 18.6%
Therefore, the appropriate discount rate to use when evaluating DEI's project, considering the increased riskiness, is approximately 18.6% (rounded to 2 decimal places).