Question

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.

Answer 1

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

.