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 $53 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $6.5 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 8.3 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. (Enter your answer in dollars, not millions of dollars, e.g. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32.) NPV $

Answer 1

Debt equity ratio will be used to calculate the weights of debt and equity. The ratio of accounts payable to long term debt can be used to calculate weights of long term debt and accounts payable and both together constitute debt. accounts payable has same cost as overall wacc

Debt equity ratio = 0.8/1

ratio of accounts payable to long-term debt = 0.15/1

accounts payable weight = 0.15/ 1.15 = 0.13

long-term debt weight = 1/1.15 = 0.87

WACC = (cost of equity * equity /total capital) + (cost of debt * debt /total capital)

= 1/1.8 * 0.14 + 0.8/1.8 [(0.15/ 1.15 * WACC) + 1/1.15 * 0.08 (1-0.35)]

= 0.0784 + 0.44 [ 0.13 wacc + 0.0452]

WACC =  0.0784 + 0.0572 WACC + 0.02

0.9428 WACC = 0.0984

WACC = 10.44%

case 1 : flotation cost = 8.3% of amount raised = 53m * 8.3% = 4.399m

total investment = 53m + 4.399m= 57.399m

present value of perpetual cash inflows = cash inflow / required rate of return  = 6.5 / 0.14 = 46.4286

NPV = present value of cash inflow - initial investment = 46.4286 - 57.399 = (10.9704)

case 2

flotation cost = 5% of amount raised = 53m *5% = 2.65m

total investment = 53m + 2.65 = 55.65m

present value of perpetual cash inflows = cash inflow / discount rate = 6.5 / 0.08 = 81.25

NPV = 81.25 - 55.65 = 25.6m

case 3

initial investment = 53m wacc = cost

perpetual cash inflows = 6.5 / WACC = 6.5 / 0.1044 = 62.2605m

NPV = 62.2605 - 53 = 9.2605m