Case Study: Defense Electronics, Inc.

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

Instructor: Elmir Musayev

23.04.2015

Case Study: Defense Electronics, Inc.

Executive summaryDefense 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 projects initial time 0 cash flow, taking into account all side effects.

Cash Flow 0=Opportunity cost of land+ Investment on net working Capital+ Equipment cost=5.1+1.3+35=$41.4 millionSo, 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 DEIs 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: 9,000,000Price per share: $71Beta: 1.2Market risk premium: 8%Risk-free rate: 5%Market value of common equity: # of shares*price per share=9,000,000*71=639,000,000Cost 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=40Total market value of a bond: 240,000*940=225,600,000Cost of debt will be actually our YTM: 940=1037.5/(1+r)40+37.5*(1-1/(1+r)40)/rYTM=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: 400,000Price per share: $81Preferred stock outstanding: 5.5%Total market value of preferred stock: 400,000*81=32,400,000Cost of preferred stock=dividend/price=5.5/81=0.068=6.8Total market value of the firm: 32,400,000+225,600,000+639,000,000=897,000,000Weight of common equity: 639,000,000/897,000,000=0.71Weigh of debt: 225,600,000/897,000,000=0.25Weight 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 10.37Debt: 25% 5.27 1.32Preferred 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=4,375,000Book value of equipment at the end of project: 35,000,000-5*4,375,000=35,000,000-21,875,000=13,125,000After-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 *TSales=18,000*10,900=196,200,000Costs=Variable cost + Fixed cost=18,000*9,400+7,000,000=176,200,000OCF=(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, lets look at cash flows throughout the 5 year:

Years Cash flows (we calculated the cash flows in previous sections)0 -41,400,000 1 14,531,2502 14,531,2503 14,531,2504 14,531,2505 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)