Subject: Business / Finance
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 Ultra Electronics, Inc. (UEI), a large, publicly traded firm that is the market share leader in radar detectors (RDs). The company is looking at setting up a manufacturing plant overseas to produce a new line of RDs. This will be a five-year project. The company bought some land three years ago for $8 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. The land was appraised last week for $10.2 million. The company wants to build its new manufacturing plant on this land; the plant will cost $30 million to build. The following market data on UEI’s securities are current:
Debt: 25,000 7 percent coupon bonds outstanding, 15 years to
maturity, selling for 92 percent of par; the bonds have a
$1,000 par value each and make semiannual payments.
Common Stock: 450,000 shares outstanding, selling for $75 per share;
the beta is 1.3.
Preferred stock: 30,000 shares of 5 percent preferred stock outstanding,
selling for $72 per share.
Market: 8 percent expected market risk premium; 5 percent risk-free rate.
UEI uses Finstearns as its lead underwriter. Finstearns charges UEI spreads of 9 percent on new common stock issues, 7 percent on new preferred stock issues, and 4 percent on new debt issues. Finstearns has included all direct and indirect issuance costs (along with its profit) in setting these spreads. UEI’s tax rate is 35 percent. The project requires $900,000 in initial net working capital investment to get operational. Assume Finstearns raises all equity for new projects externally.
a. Calculate the project’s initial time 0 cash flow, taking into account all side effects.
b. The new RD project is somewhat riskier than a typical project for UEI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating UEI’s project.
c. The manufacturing plant has an eight-year tax life, and UEI uses straight-line
depreciation. At the end of the project (that is, the end of year 5), the plant can
be scrapped for $5 million. What is the aftertax salvage value of this
d. The company will incur $400,000 in annual fixed costs. The plan is to
manufacture 17,000 RDs per year and sell them at $10,000 per machine; the
variable production costs are $9,000 per RD. What is the annual operating
cash flow (OCF) from this project?
e. Finally, UEI’s present 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 what the RD project’s internal rate of return (IRR) and net present value
(NPV) are. What will you report?