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

The company has a capital budgeting project of building a new $50 million project. This project will generate $6.2 million of 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 will mean equity of $100 will be issued. So out of $50 million, company will collect $50*100/180 = $27.78 million 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 $27.78 million, then actual amount of new equities issued is -

$27.78 million x (100/92) =$30.19 million

Now consider debt amount. If total fund requirement is $50 million and debt equity ratio is 0.8, then $50x (80/180)=$22.22 million 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 $22.22 million is to be collected from debt. Out of this -

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

$22.22 x (100 /115) = $19.32 million

2. Amount collected by increasing accounts payable is -

$22.22 x (15/115) = $2.90 million

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 inorder to collect $19.32 million total value of bond required to be issued is $19.32 x (100/96) = $20.125 million.

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

1. Equity share of $30.19 million

2. 8%, 20 years Bond of $20.125 million and

3. By increasing accounts payable of $2.90 million.

Note that accounts payable is a part of companys ongoing business. So calculation of cost of capital will not consider it. It has been clearly mentioned that weighted average cost of capital (WACC) is the cost of this accounts payable.

Cost of equity here is 14% and cost of bond is 8%. Thus Calculation of weighted average cost of capital is-

=(30.19*0.14)+(20.125*0.08)/30.19+20.125
=11.6%

This WACC is also applicable on the accounts payable.

Now let us calculate PV of perpetuity

PV = A/r

=6.2/11.6%

53.44 million

NPV = 53.448-50 = 3.448 million

hence project should be accepted