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University of Florida FINC

Project Evaluation
This is a comprehensive project evaluation problem bringing together much of what you have
learned in this and previous chapters. 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 $6 million in anticipation of using it as a toxic dumps site for
waste chemicals, but it built a piping system to safely discard the chemicals instead. The land
was appraised last week for $4.25 million. The company wants to build its new manufacturing
plant on this land; the plant will cost $7.2 million to build. The following market data on DEI’s
securities are current:
Debt: 10,000 8% coupon bonds outstanding, 15 years to maturity selling for
94% of par; the bonds have a $1,000 par value each and make
semiannual payments.
Common Stock: 250,000 shares outstanding, selling for $65 per share; the beta is 1.3.
Preferred stock: 10,000 shares of 7% preferred stock outstanding, selling for $81 per
Market: 8% expected market risk premium; 5.65% risk-free rate
DEI’s tax rate is 34%. The project requires $750,000 in initial net working capital investment to
get operational.
a. Calculate the project’s Time 0 cash flow, taking into account all side effects.
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 adjusted factor
of +2% to account for this increased riskiness. Calculate the appropriate discount rate
to use when evaluating DEI’s project.
c. The manufacturing plant has an eight-year tax life, and DEI uses straight line
depreciation. At the end of the project (i.e., the end of Year 5), the plant can be
scrapped for $2 million. What is the after-tax salvage value of this manufacturing plant?
d. The company will incur $900,000 in annual fixed costs. The plan is to manufacture
10,000 RDSs per year and sell them at $10,000 per machine; the variable production
costs are $9,100 per RDS. What is the annual operating cash flow, OCF, from this
e. Finally, DEI’s president wants you to throw all your calculations, all your assumptions,
and everything else into a report for the chief financial officer; all he wants to know is
what the RDS project’s internal rate of return, IRR, and net present value, NPV are.
What will you report?


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