Case Study: Defense

Electronics, Inc.
Group members: Farida Asgarova, Hasan
Rzayev, Jeyhun Hasanov, Baba Abbasov, Jasur
Fayziev
Instructor: Elmir Musayev

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 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 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 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: 9,000,000
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: 240 000

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=35,000,00021,875,000=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)*(10.35)+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)/(10,9009,400)=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
0
1
2
3
4
5

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

-41,400,000
14,531,250
14,531,250
14,531,250
14,531,250
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)