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

Solution:

Company has a proposal of building a new $50 million project. This project will generate $6.2 million after tax cash inflow in perpetuity.

This project will be financed from three sources. They are-

1. New issue of equity

2. 8% 20 years bond and

3. By increasing accounts payables.

Company wants to maintain a debt equity ratio of 0.80. Thus issue of debt capital of $80 mean issue of equity of $100 . So out of $50 million, company will collect $50,000,000*100/180 = $27,777,777 fund from equity issue.

Further it has been mentioned that flotation cost of equity share is 8%.

Thus 100-8=92% of total issue value is the net fund received from new equity. If net collection from equity is $27,777,777, then actual amount of new equities issued is -

$27,777,777 million x (100/92) =$30,193,236

Now consider debt amount. If total fund requirement is $50 million and debt equity ratio is 0.8, then $50,000,000 x (80/180)=$22,222,222 will be collected from debt capital.

There are two sources of debt capital. First one is long term 8% bond. Second one is short term debt in the form of accounts payable. Ratio of Accounts payable to long term debt is 0.15. It implies that if $100 is collected from bond issue then $15 accounts payable source.

Here $22,222,222 is to be collected from debt. Out of this -

1. Amount collected from 8% 20 years bond is-

$22,222,222 x (100 /115) = $19,323,671

2. Amount collected by increasing accounts payable is -

$22,222,222 x (15/115) = $2,898,551

Now consider 8% bond. At the time of issuing bond company has to incur flotation cost of 4%. Thus against $100 new bond issued $4 is paid as flotation cost. So net fund collected from this source is $100-$4=$96. So in order to collect $19,323,671 total value of bond required to be issued is $19,323,671 x (100/96) = $20,128,824.

Thus for getting total fund of $50 million, company will issue-

1. Equity share of $30,193,236

2. 8%, 20 years Bond of $20,128,824 and

3. By increasing accounts payable of $2,898,551

WACC = (Equity Issued * Cost of Equity/Total Issue) + (Debt Issued * Cost of Debt/Total Issue) + (Accounts payable * WACC/Total Issue)

WACC = (30,193,236*14/53220611) + (20128824*8(1-0.35)/53220611) + (2898551*WACC/53220611)

WACC = 7.94 + 1.97 + 0.0545 WACC

WACC = 10.48%

Now consider cash inflow from this new project. It will generate after tax cash flow of $6.2 million in each year.

Calculating present value of cash inflows  by using WACC as discounting rate.The figure is-

= $6,200,000/1.1048 + $6,200,000/1.1048^2 + .......upto infinity

= ($6,200,000/1.1048) / (1 - 1/1.1048) = $5,611,875 / 0.0458 = $122,530,021

Net Present Value = $122,530,021 - $53,220,611 = $69,309,410