Question

Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt-equity ratio of .75. It’s considering building a new $71 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $7.9 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 6.8 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 2.5 percent of the proceeds. If the company issues these new bonds at an annual coupon rate of 5 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 24 percent tax rate. (Do not round intermediate calculations and enter your answer in dollars, not millions, rounded to the nearest whole dollar amount, e.g., 1,234,567.)

Answer 1

Step 1: Determine Accounts Payable and Long-Term Debt Weight

The value of accounts payable and long-term debt weight is determined as below:

Accounts Payable Weight = .15/(1+.15) = .15/1.15

Long-Term Debt Weight = 1/(1+.15) = 1/1.15

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Step 2: Calculate WACC

The WACC is arrived as follows:

WACC = 1/(1+Target-Debt to Equity Ratio)*Cost of Equity + Target-Debt to Equity Ratio/(1+Target-Debt to Equity Ratio)*[(.15/1.15)*WACC + 1/1.15*Annual Coupon Bond*(1-Tax Rate)]

Substituting values in the above formula,

WACC = 1/(1+.75)*14% + .75/(1+.75)[(.15/1.15)*WACC + 1/1.15*5%*(1-24%)]

Solving further,

WACC = .08 + .4286[(.15/1.15)*WACC+ 0.0330]

WACC = .08 + .05590*WACC + .0142

WACC = (.08 + .0142)/(1 - .05590) = 9.97%

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Step 3: Calculate Weighted Average Flotation Cost

The value of weighted average flotation costs is calculated as below:

Weighted Average Flotation Cost = 1/(1+Target-Debt to Equity Ratio)*Flotation Cost of Equity + Target-Debt to Equity Ratio/(1+Target-Debt to Equity Ratio)*[(.15/1.15)*0 + 1/1.15*Flotation Cost of Bond]

Substituting values in the above formula,

Weighted Average Flotation Cost = 1/(1+.75)*6.8% + .75/(1+.75)*[(.15/1.15)*0 + 1/1.15*2.5%] = 4.82%

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Step 4: Calculate NPV

The NPV is determined as follows:

NPV = -Amount Raised + Annual After-Tax Cash Flow/WACC = -71,000,000/(1-4.82%) + 7,900,000/9.97% = $4,614,671.81

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Notes:

There can be a slight difference in final answer on account of rounding off values.