Question

Retlaw Corporation (RC) manufactures time series photographic equipment. It is currently at its target debt/equity ratio of 0.74. It’s considering building a new $48 million manufacturing facility. This new plant is expected to generate after-tax cash flows of $8.4 million in perpetuity. The company raises all equity from outside financing. There are three financing options: 1. A new issue of common stock: The flotation costs of the new common stock would be 7 percent of the amount raised. The required return on the company’s new equity is 14 percent. 2. A new issue of 20-year bonds: The flotation costs of the new bonds would be 4 percent of the proceeds. If the company issues these new bonds at an annual coupon rate of 8.0 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, it has no flotation costs, and 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 0.135. (Assume there is no difference between the pre-tax and after-tax accounts payable cost.) What is the NPV of the new plant? Assume that RC has a 45 percent tax rate

Answer 1

		Debt/Equity=0.74
		Debt=0.74*Equity
		Total Capital =(1+0.74)Equity
		Weight of Debt in total capital=0.74/1.74	0.425287356
		AccountsPayable =0.135*Long TermDebt
		Total Debt Capital =(1+0.135)*Long TermDebt
	Wd	Weight of Long Term Debtin total capital =0.425287/1.135=	0.374702517
	Wa	Weight of accounts payablein total capital =0.425287-0.374703=	0.05058484
	We	Weight of Equity in total capital=1/1.74	0.574712644
		Cost of New Equity Issue:
		Required Return	14%
		Flotation Cost=7%=0.07
	Ce	Cost of Equity =14/(1-0.07)=	15.05%
		Cost of new issue of Bonds
		Annual Coupon cost	8%
		Flotation Cost=4%=0.04
		Before tax cost of Bond =8/(1-0.04)	8.33%
		Tax Rate=45%=0.45
	Cd	After tax cost of Long term debt =8.33*(1-0.45)	4.58%
		Weighted Average Cost of Capital (WACC):
		WACC =Weight of Equity * Cost of Equity +Weight of Long TermDebt* Cost of Long TermDebt+Weight of accounts payable*WACC
		WACC=We*Ce+Wd*Cd+Wa*WACC=0.574713*15.05+0.374703*4.58+0.050585*WACC
		WACC*(1-0.050585)=0.574713*15.05+0.374703*4.58=	0.10369
		WACC=0.10369/(1-0.050585)=	0.109214337
		WACC=	10.92%
	I	Initial Outlay	$48	million
		Annual after tax cash inflow in perpetuity	$8.40	million
	PV	Present Value of Cash inflow in perpetuity=8.4/WACC	$76.91	million
	NPV=PV-I	Net Present value (NPV) of the new plant=76.91-48	$28.91	million
		NPV=	$28,912,979