This is a comprehensive project evaluation problem bringing

no exame

together much of what you have learned in this and previous chapters. Suppose you have

been hired as a financial consultant to Defence Electronics International $($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 $5-$year project. The company bought some land three years ago for $7$

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 company sold the land today, it

would receive $6\mathrm{.}5$ million after taxes. In $5$ years the land can be sold for $4\mathrm{.}5$ million

after taxes and reclamation costs. 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: $150,0007$ per cent coupon bonds outstanding, $15$ years to maturity, selling for $92$ per cent of

par; the bonds have a $100$ par value each and make semi$-$annual payments.

Equity: $300,000$ shares outstanding, selling for $75$ per share; the beta is $1\mathrm{.}3.$

Preference shares: $20,000$ shares with $5$ per cent dividends outstanding, selling for $72$ per share.

Market: $8$ per cent expected market risk premium; $5$ per cent risk$-$free rate.

DEI$$s tax rate is $28$ per cent. The project requires $900,000$ in initial net working capital

investment to become operational.

$($a$)($b$)$ Calculate the project$$s initial time $0$ cash flow, taking into account all side effects.

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 $+2$ per cent to account for this increased riskiness. Calculate the

appropriate discount rate to use when evaluating DEI$$s project.

The manufacturing plant has an $8-$year tax life, and DEI uses $20$ per cent reducing

balance depreciation for the plant. At the end of the project $($i$.$e$.,$ the end of year $5),$

the plant can be scrapped for $5$ million. What is the after$-$tax salvage value of this

manufacturing plant?

The company will incur $400,000$ in annual fixed costs. The plan is to manufacture

$12,000$ RDSs per year and sell them at $10,000$ per machine; the variable production

costs are $9,000$ per RDS$.$ What is the annual operating cash flow $($OCF$)$ from this

project?

DEI$$s comptroller is primarily interested in the impact of DEI$$s investments on the

bottom line of reported accounting statements. What will you tell her is the accounting

break$-$even quantity of RDSs sold for this project?

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 wants to know is

the RDS project$$s internal rate of return, IRR, and net present value, NPV $.$ What will

you report?