Question

Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt?equity ratio of .85. It’s considering building a new $55 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $6.7 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 8.5 percent of the amount raised. The required return on the company’s new equity is 13 percent.
2.	A new issue of 20-year bonds: The flotation costs of the new bonds would be 4.0 percent of the proceeds. 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, 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 .20. (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 40 percent tax rate. (Enter your answer in dollars, not millions of dollars, e.g. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32.)

Answer 1

The company wants to maintain a debt equity ratio of 0.85
it means for every $85 raised through debt $100 has to be equity
Amount raised from equity issue will be =	55000000*100/185
=	29,729,729.73
Cost of flotation=	8.50%
Net Equity received =	100%-8.5%
=	91.50%
Net collection from equity=	29,729,729.73
Total amount to be raised via equity=	29729729.73/91.50%
=	32,491,507.90
Amount of Debt to be raised =	55000000*85/185
=	25,270,270.27
There are 2 sources for Debt: Bonds and Accounts Payable
Ratio of accounts payable to long term debt=	0.2
This means for every 100$ of long term debt, $20 to be raised via accounts payable
Amount to be raised as accounts payable financing =	25270270.27/120*20
=	4,211,711.71
Amount to be raised as longterm debt (bonds) =	25270270.27/120*100
	21,058,558.56
Cost of flotation of bonds=	4%
Net % of amount of bond=	100%-4%
=	96.00%
Net amount on bonds received =	21,058,558.56
Total amount to be raised via bonds=	21058558.56/96%
=	21,935,998.50
Amount raised from Equity	32,491,507.90
Amount raised from Bonds	21,935,998.50
Amount raised via Accounts Payable	4,211,711.71
	58,639,218.11
Since accounts payable is a part of the ongoing business it will not be considered for calculating cost of capital
Cost of Equity	13%
Cost of Debt	7%
WACC=( Cost of Equity * Equity issued + Cost of Debt(1-tax rate) * Debt issued )/ (Equity Issued + Debt Issued)
WACC=	((0.13*32491507.9) + ((0.07*(1-0.40))*21935998.50))/(32491507.90+21935998.50)
=	0.0945
=	9.45%
The above WACC is also applicable to accounts payable
Cashflows
After Tax cash Inflow for perpetuity=	6,700,000.00
PV of Cash inflow =	6700000/0.0945
=	70,899,470.90
Initial Investment	58,639,218.11
NPV	12,260,252.79

NPV of the project is $12,260,253