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

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)

NPV = $50000000 - $59160305

NPV = $9160305