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.

Answer 1

Solution

Working Notes - Calculation of amount financed by different mode

1) Equity Finance

Total Finance - $50 million

Debt equity ratio = 0.8

Hence debt is 80% of 100% equity

Equity Portion = ($50 million*100/180) = $27.78 Million

Flotation cost = 8%.

Net Proceeds = 100% - 8% = 92%

Total Equity capital issued = $27.78 Million/92% = $30.19 Million

2) Debt Portion = $50 Million - $27.78 Million = $22.22 Million

Debt account payable ratio = 0.15

Debt portion = 100% = $22.22 Million * 100/115 = $19.32 Million

Flotation cost of debt = 4%

Net proceeds = (100% - 4%) = 96% = ($19.32 Million/96%) = $20.125 Million

Accounts payable portion = 15% = $22.22 Million *15/115 = $2.9 Million

Step 1 - Calculation of WACC

Accounts payable is part of ongoing business and also it is mentioned that wacc cost is the cost of accounts payable

Total Capital = $30.19 Million + $20.125 Million + $2.9 Million = $53.215 Million

Let WACC Rate = 'x'

Particulars	Cost	Ratio	WACC
Cost of equity	14%	0.57 ($30.19/$53.215)	7.98%
Cost of debt (sell at par)	8%*(1 - tax rate of 35%) = 5.2%	0.38 ($20.125/$53.215)	1.976%
Accounts Payable	x (wacc rate)	0.05 ($2.9/$53.215)	0.05x
	Total	1.0	x (SEE EQUATION)

Equation :-

x = 7.98% + 1.976% + 0.05x

0.95x = 9.956%

x = 10.48% (WACC)

Step 2 - Calculation of NPV

Cash flow after Tax = $6.2 Million (Perpetual)

NPV = $50 Million - (Cash flow After tax / 0.1048 of WACC)

NPV = $50 Million - ($6.2 Million / 0.1048) = $9.16 Million