Question

Retlaw Corporation (RC) manufactures time-series photographic equipment. It is currently at its target debt–equity ratio of 0.75. It’s considering building a new $40 million manufacturing facility. This new plant is expected to generate after-tax cash flows of $7.6 million in perpetuity. The company raises all equity from outside financing. There are three financing options:

A new issue of common stock: The flotation costs of the new common stock would be 9% of the amount raised. The required return on the company’s new equity is 16%.

A new issue of 20-year bonds: The flotation costs of the new bonds would be 4% of the proceeds.

If the company issues these new bonds at an annual coupon rate of 8.0%, they will sell at par. 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 0.170. (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 35% tax rate.

Answer 1