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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 to produce a new line of RDSs. This will be a five-year project. The company bought some land three years ago for $4.5 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. If the land were sold today, the net proceeds would be $5 million after taxes. In five years, the land will be worth $5.3 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $15 million to build. The following market data on DEI's securities are current:

Debt: 40,000 6.2 percent coupon bonds outstanding, 25 years to maturity, selling for 95 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock: 825,000 shares outstanding, selling for $97 per share; the beta is 1.25.

Preferred stock: 45,000 shares of 5.8 percent preferred stock outstanding, selling for $95 per share.

Market: 7 percent expected market risk premium; 3.8 percent risk-free rate.

DEI's tax rate is 34 percent. The project requires $825,000 in initial net working capital investment to get operational.

1. Calculate the appropriate discount rate to use when evaluating DEI's project.

2. The manufacturing plant is an eight-year project, and DEI uses 7-year MACRS to depreciate the plant to a book value of zero. At the end of the project, the plant can be scrapped for $ 0.2 million. What is the after tax salvage value of this manufacturing plant? (10 points)

Property Class 3-year 5-year 7-year

1 33.33% 20.00% 14.29%

2 44.45% 32.00% 24.49%

3 14.81% 19.20% 17.49%

4 7.41% 11.52% 12.49%

5 11.52% 8.93%

6 5.76% 8.92%

7 8.93%

8 4.46%

Total 100.00% 100.00% 100.00%

3. The company will incur $3,500,000 in annual fixed costs. The plan is to manufacture 10,000 RDSs per year and sell them at $10,800 per machine; the variable production costs are $9,900 per RDS. What are the annual operating cash flows, OCFs, from this project? (30 points)