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WACC and NPV. Photochronograph Corporation (PC) manufacturestime series photographic equipment. It is currently at its...

WACC and NPV. Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt–equity ratio of .45. It’s considering building a new $37 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $5.1 million in perpetuity. There are three financing options:

  1. A new issue of common stock: The required return on the company’s new equity is 15 percent.

  2. A new issue of 20-year bonds: If the company issues these new bonds at an annual coupon rate of 7 percent, they will sell at par.

  3. Increased use of accounts payable financing: Because this financing is part of the company’s ongoing daily business, the company assigns it a cost that is the same as the overall firm WACC. Management has a target ratio of accounts payable to long-term debt of .15. (Assume there is no difference between the pretax and aftertax accounts payable cost.)

What is the NPV of the new plant? Assume that the company has a 35 percent tax rate.

Solutions

Expert Solution

WACC = [re x we] + [rd x (1−T)x wd], where

  • re is the cost of equity,
  • rd is the cost of debt,
  • T is the tax rate, and
  • wi is the corresponding market weight, for example we = we / [we + wd]

Since the target Debt / Equity ratio is 0.45, Debt represents 0.45 / 1.45 = 31% of the company and Equity represents the remaining 69%

Using the WACC formula,

WACC = [0.15 x 0.69] + [0.07 x (1 - 0.35) x 0.31] = 0.1035 + 0.0141 = 0.1176, or 11.76%

Let,

  • I = initial investment
  • CF = subsequent cash flows
  • r = cost of capital

The net present value (NPV) formula for perpetual cash flows is:

NPV = −I + [CF/r] = −37 + [5.1 / 0.1176] = - 37 + 43.37 = 6.37

The NPV is $6.37 mil

.


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