Question

Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt−equity ratio of .80. It’s considering building a new $50 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $6.2 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 8 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 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 .15. (Assume there is no difference between the pretax and aftertax accounts payable cost.) What is the NPV of the new plant? Assume that PC has a 35 percent tax rate. (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount.)

Answer 1

Cost to the firm or the dicount rate in various scenarios:

A) Equity Financing = 14%

B)Debt Financing = After tax at 5%

C) In case the company cosider using Accounts Payable to finance, the comapny consider the cost to be the same as WACC of the overall firm.

Calculation of the WACC for the overall firm:

Debt/Capital = (D/E) / [1 + D/E] = 0.80 / 1.80 = 0.44 < weight of debt
Weight of equity = 1 - Weight of Debt = 1 - 0.44 = 0.56

Now asssuming

Cost of Debt, Pre Tax = 8%

Cost of Debt, Post Tax = 8%(1-35%) = 5%

Cost of Equity = 14%

WACC = (Cost of Debt * Weight of Debt) + (Cost of Equity * Weight of Equity)

= (5% * 0.44) + (14% * 0.56)

=10.04%

Since, in financing of Accounts payable, the company would get tax benefit.

SO post tax rate for Accounts Payable financing = =10.04%*(1-35%) = 6.53%

In all the scenarios, the cash flow has been discount using the cost of capital as mentioned.

Since the cash flow is $6.2 million till perpetuity, Growth rate has been considered 0%

Since the Net Present Value is highest when financing throught Debt, the company should consider financing the project through Debt.