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

Photograph Corporation (PC) is evaluating a capital budgeting problem by calculating NPA (Net Present Value) of its intended investment of $50 million on manufacturing facility. The project is expected to generate $6.2 million after tax cash flows.

PC has three sources to finance this project:

1. New issue of equity
2. 8% 20 years bond and
3. By increasing accounts payables

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The current and the target Debt to Equity ratio is .80 (80/100), which means if company had issued equity worth $100 then it must issue $80 worth of debt capital.

So, for $50 million:

Equity Capital Issue: $50 million * (100/180) = $27,777,777.8

Floatation cost = 8% (these are the costs that are incurred by the companies while raising capital e.g. underwriting fees, legal fees, road shows, registration fees etc.)

Hence 92% (100 – 8%) of the equity issue is the net fund value available with the company. So, for meeting the project requirement of $27,777,777.8 the company has to issue equity amounting $27,777,777.8 * (100/92) = $30,184,782.6

Debt Capital Issue: $50 million * (80/180) = $22,222,222.2

Company has two sources of debt capital: Long term 8% bond and short-term accounts payables.

Target ration of short term accounts payable and long term 8% bonds is .15 (15/100), which means if company finance $100 from long term bonds then $15 has to be finance via accounts payables.

8% Bonds: $22,222,222.2* (100/115) = $19,321,739.1

                Floatation cost = 4%

Hence actual bond issue to made is: $19,321,739.1* (100/96) = $20,126,811.5

Accounts Payables: $22,222,222.2 * (15/115) = $2,898,550.69

Now, we need to calculate the Weighted Average Cost of Capital for the company:

R_WACC = [Equity Issued * Cost of Equity + Debt Issued * Cost of Debt (1- Tax rate) ] / (Equity Issued + Debt Issued )

Tax Rate = 35%

Cost of Equity = 14%

Cost of Debt = 8%

Cost of Accounts Payble = R_WACC

Note: Cost of Debt should be post tax since interest of debt reduces net profit and hence the tax liability. This is cost debt tax shield.

Accounts Payable will not be included in the WACC calculation since it's not an external source of financing and since it generates in ongoing business operations one cannot incurr opportunity cost on the investment in these funds.

It’s mentioned that the cost of accounts payable will be WACC of the company.

So, on putting values on this WACC’s equation:

R_WACC = {$30,184,782.6 * .14 +    $20,126,811.5 * .08 (1-.35) } / {$30,184,782.6 + $20,126,811.5}

R_WACC = (4225869.56+ 1046594.17) / ($50,311,594.10)

R_WACC = (5272463.73) / ($50,311,594.10)

R_WACC = 0.104796197 i.e. 10.4796197%

Final step is to calculate the Net Present Value (NPV) of the project:

NPV = - Initial Investment + (After tax Cash Flows / R_WACC)

Note: The $6.2 million cash flows are after tax and till perpetuity.

NPV = - $50,000,000 + ($6,200,000 / 0.104796197)

NPV = - $50,000,000 + $59,162,452.24

NPV =   $9,162,452.24

Since NPV of project is $9,162,452.24, which is positive hence company should accept the project.