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 $3.8 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 $4.6 million. In five years, the aftertax value of the land will be $5.0 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 $31.44 million to build. The following market data on DEI’s securities are current:
Debt:
223,000 7.0 percent coupon bonds outstanding, 25 years to maturity, selling for 107 percent of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock:
8,100,000 shares outstanding, selling for $70.30 per share; the beta is 1.3.
Preferred stock:
443,000 shares of 4 percent preferred stock outstanding, selling for $80.30 per share.
Market:
6 percent expected market risk premium; 4 percent risk-free rate.
DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 7 percent on new common stock issues, 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. 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 40 percent. The project requires $1,125,000 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.)
Cash flow $
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 1 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))
MVD = 223000(1000)(1.07)=
MVE =8100000(70.30) =
MVP = 443000(80.3) =
add them up to market value
Now, we can find the cost of equity using the CAPM. The cost of equity is:
RE = 0.04 + 1.13(0.60) =
What is the YTM?
$5.1 million+$35million
900009$
To calculate the project's initial time 0 cash flow, we need to consider all the relevant factors:
1. Land: The land was purchased for $3.8 million and is now appraised at $4.6 million. However, the company expects to keep the land for a future project, and its aftertax value in five years will be $5.0 million. Therefore, the opportunity cost of using the land for the new plant is the present value of its aftertax value in five years:
Opportunity cost of land = $5,000,000 * (1 - tax rate)
2. Plant and Equipment: The cost of building the plant and equipment is given as $31.44 million.
3. Initial Net Working Capital (NWC) Investment: The project requires an initial NWC investment of $1,125,000.
Now let's calculate the initial time 0 cash flow:
Initial cash flow = Opportunity cost of land + Plant and Equipment cost + Initial NWC investment
= ($5,000,000 * (1 - 0.40)) + $31,440,000 + $1,125,000
= $3,000,000 + $31,440,000 + $1,125,000
= $35,565,000
Therefore, the initial time 0 cash flow for the project is $35,565,000.
To calculate the appropriate discount rate, we need to adjust the required rate of return for the increased riskiness of the overseas project. The adjustment factor given is 1 percent.
Risk-free rate = 4%
Market risk premium = 6%
Adjusted discount rate = Risk-free rate + Beta * Market risk premium + Risk premium adjustment
Since the beta for DEI is not given in the information provided, we cannot determine the exact adjusted discount rate. We need to know the beta to calculate it using the formula above.