Case Study: Defense Electronics, Inc.
Group members: Farida Asgarova, Hasan Rzayev, Jeyhun Hasanov, Baba Abbasov, Jasur Fayziev /
Instructor: ElmirMusayev
23.04.2015 /

Case Study: Defense Electronics, Inc.

Executive summary

Defense Electronics, Inc. (DEI) is going to implement a five-year project called Radar Detection Systems (RDSs). Capital structure of the company consists of debt, common equity and preferred stock. DEI should invest money on NWC and equipment to be able to start. It will also have fixed and variable costs during the production process. However, the cash inflows will allow the company to cover all its cost and get benefit in the long run if everything goes as expected. All in all, the project is going to increase the revenues of DEI since the NPV of the project is quite bigger than zero. The IRR of the project also confirms the profitability of RDS project in terms of being greater than required return. In the following sections of the case study you can see how we came to this conclusion:

a) Calculate the project’s initial time 0 cash flow, taking into account all sideeffects.

Cash Flow 0=Opportunity cost of land+ Investment on net working Capital+ Equipment cost=5.1+1.3+35=$41.4 million

So, Defense Electronics, Inc. is going to have initial cash outflow of $41.4million in order to start RDS project.

b)Calculate the appropriate discount rate to use when evaluating DEI’s project.

IN order to find the discount rate or the required return on this project, first of all, we should calculate WACC. After finding WACC for the project, we should take into account the +2% adjustment factor for the riskiness of the project.

In order to have proper WACC analysis, we should find market value of equity, debt and preferred stock and their respective costs.

Equity valuation:

Number of shares: 9,000,000

Price per share: $71

Beta: 1.2

Market risk premium: 8%

Risk-free rate: 5%

Market value of common equity: # of shares*price per share=9,000,000*71=639,000,000

Cost of equity (CAPM): R(f)+Beta*Market risk premium=0.05+1.2*0.08=0.146=14.6%

Debt valuation:

Bond: 240000 Coupon bond outstanding: 7.5%

Price: 940 Semi-annual payment: 1000*7.5%/2=37.5

Par value: 1000 Tax rate: 35 %

# of periods: 20*2=40

Total market value of a bond: 240,000*940=225,600,000

Cost of debt will be actually our YTM:940=1037.5/(1+r)40+37.5*(1-1/(1+r)40)/r

YTM=cost of debt=8.11% (web calculation)

After-tax cost of debt: 8.11%*(1-0.35)=8.11*0.65=5.27%

Preferred stock valuation:

# of shares: 400,000

Price per share: $81

Preferred stock outstanding: 5.5%

Total market value of preferred stock: 400,000*81=32,400,000

Cost of preferred stock=dividend/price=5.5/81=0.068=6.8

Total market value of the firm: 32,400,000+225,600,000+639,000,000=897,000,000

Weight of common equity: 639,000,000/897,000,000=0.71

Weigh of debt: 225,600,000/897,000,000=0.25

Weight of preferred stock=32,400,000/897,000,000=0.036=0.04

To calculate WACC:

Weights Costs WACC (weight*cost)

Common equity: 71% 14.6 10.37

Debt: 25% 5.27 1.32

Preferred stock: 4% 6.8 0.27

Total WACC: 11.96%

Projected required return is: 11.96%+2%=13.96%

c)What is the after-tax salvage value of equipment?

Depreciation: 35,000,000/8=4,375,000

Book value of equipment at the end of project: 35,000,000-5*4,375,000=35,000,000-21,875,000=13,125,000

After-tax salvage value is: 6,000,000+0.35*(13,125,000-6,000,000)=8,493,750

d)What is annual OCF of the project?

Using the tax shield formula we can calculate OCF per year:

OCF = (Sales – Costs) * (1-T) + Depreciation *T

Sales=18,000*10,900=196,200,000

Costs=Variable cost + Fixed cost=18,000*9,400+7,000,000=176,200,000

OCF=(196,200,000-176,200,000)*(1-0.35)+0.35*4,375,000=20,000,000*0.65+1,531,250=13,000,000+1,531,250=$14,531,250

e)Accounting break-even: (Fixed cost + Depreciation)/(Price-Cost)=(7,000,000+4,375,000)/(10,900-9,400)=11,375,000/1,500=7,583.3 units

f)Find the NPV and the IRR of the project.

To calculate NPV and IRR, let’s look at cash flows throughout the 5 year:

Years Cash flows (we calculated the cash flows in previous sections)

0 -41,400,000

1 14,531,250

2 14,531,250

3 14,531,250

4 14,531,250

5 31,325,000 (14,531,250+8,493,750+7,000,000+1,300,000)

NPV of the project:$17,272,420.25(web calculation)

IRR of the project:28.31%(web calculation)