. Calculate the project’s Time 0 cash flow, taking into account all side effects.

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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 Defence Electronics Ltd (DEL), a large, publicly traded firm that is the market-share leader in radar detection systems (RDSs). The company is considering 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 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 $6.4 million after taxes. In five years, the land will be worth $7 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $9.8 million to build. The following market data on DEL’s securities are current:

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Debt: twenty-five thousand 6.5% coupon bonds outstanding, twenty years to maturity, selling for 96% of par; the bonds have a $1000 par value each and make half-yearly payments.

Ordinary shares: 400 000 ordinary shares outstanding, selling for $89 per share; the beta is 1.2.

Preference shares: thirty-five thousand 6.5% preference shares outstanding, selling for $99 per share.

Market: 8% expected market risk premium; 5.2% risk-free rate.

DEL’s tax rate is 30%. The project requires $825 000 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 DEL, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +2% to account for this increased riskiness. Calculate the appropriate discount rate to use under a classical tax system when evaluating DEL’s project.

c. The manufacturing plant has an eight-year tax life, and DEL uses straight-line depreciation. At the end of the project (i.e. the end of Year 5), the plant can be scrapped for $1.25 million. What is the after-tax salvage value of this manufacturing plant?

d. The company will incur $2 100 000 in annual fixed costs. The plan is to manufacture 11 000 RDSs per year and sell them at $10 000 per machine; the variable production costs are $9300 per RDS. What is the annual operating cash flow (OCF) from this project?

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e. Finally, DEL’s management 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 are the RDS project’s internal rate of return, IRR and net present value (NPV). What will you report?

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