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:
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?
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?