Question

Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt?equity ratio of .8. It’s considering building a new $48 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $6 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 7.8 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 5.0 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

Cost of equity	14%
Floatation cost	7.80%
Effective cost	14/(100-(100*7.8%))
Effective cost	15.18%
Cost of debt	8.00%
Floatation cost	5.00%
Effective cost	5/(100-(100*5%))
Effective cost	5.263%
Tax rate	35%
After tax cost of debt	=5.263% * (1-35%)
After tax cost of debt	3.421%
Debt	0.8
Equity	1
	1.8
Accounts payable	0.15	0.104348
long term debt	1	0.695652
	1.15	0.8
So we have bifurcated AP and Long term debt in same ratio for 0.8
Component	Cost	Capital	Weight	Cost * Weight
Accounts payable	C	0.104	5.80%	C * 0.058
Debt	3.42%	0.696	38.65%	1.32%
Equity	15.18%	1.000	55.56%	8.44%
		1.800
C*0.058 + 9.76% =	C
0.942 * C=	9.76%
C=	9.76%/0.942
C=	0.103609
WACC	10.36%
Expected free cash flow	6
PV of future cash flows	6/10.36%
PV of future cash flows	57.92
Initial Cost	(48.00)
NPV	9.92