$8$

$.$

$$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 $

$3$

$.$

$9$

$$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 $

$4$

$.$

$1$

$$million on an aftertax basis. In five years, the aftertax value of the land will be $

$4$

$.$

$4$

$$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 $

$3$

$7$

$$million to build. The following market data on DEI

$$

s securities is current:

$$

$$ Debt:

$2$

$0$

$5$

$,$

$0$

$0$

$0$

$$bonds with a coupon rate of

$5$

$.$

$8$

$$percent outstanding,

$2$

$5$

$$years to maturity, selling for

$1$

$0$

$6$

$$percent of par; the bonds have a $

$1$

$,$

$0$

$0$

$0$

$$par value each and make semiannual payments.

$$

$$ Common stock:

$8$

$,$

$6$

$0$

$0$

$,$

$0$

$0$

$0$

$$shares outstanding, selling for $

$6$

$7$

$$per share; the beta is

$1$

$.$

$1$

$5$

$.$

$$

$$ Preferred stock:

$5$

$0$

$0$

$,$

$0$

$0$

$0$

$$shares of

$4$

$$percent preferred stock outstanding, selling for $

$8$

$3$

$$per share; the stock has a par value of $

$1$

$0$

$0$

$.$

$$

$$ Market:

$7$

$$percent expected market risk premium;

$3$

$.$

$1$

$$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

$2$

$5$

$$percent$.$ The project requires $

$1$

$.$

$5$

$$million in initial net working capital investment to get operational. Assume DEI raises all equity for new projects externally.

$$

Before answering questions, calculate a few basic things:

a

$.$

$$Estimate the MV of Common Stock

$($

ie Equity

$)$

$,$

$$Preferred and Debt. Prices and their quantities are given. So now you have the proportion of equity, debt and preferred in the capital structure.

b

$.$

$$Estimate the cost of equity

$($

using CAPM

$)$

$,$

$$debt

$($

use RATE function in Excel to get the YTM

$)$

$$ and preferred

$($

annual dividend

$/$

price per share

$)$