University of Florida FINC
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 DEIâ€™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
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
DEIâ€™s tax rate is 34%. The project requires $750,000 in initial net working capital investment to
a. Calculate the projectâ€™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 DEIâ€™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, DEIâ€™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 projectâ€™s internal rate of return, IRR, and net present value, NPV are.
What will you report?