Question

Retlaw Corporation (RC) manufactures time-series photographic equipment. It is currently at its target debt–equity ratio of 0.75. It’s considering building a new $40 million manufacturing facility. This new plant is expected to generate after-tax cash flows of $7.6 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 9% of the amount raised. The required return on the company’s new equity is 16%.
2. A new issue of 20-year bonds: The flotation costs of the new bonds would be 4% of the proceeds. If the company issues these new bonds at an annual coupon rate of 8.0%, 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 0.170. (Assume there is no difference between the pre-tax and after-tax accounts payable cost.).        What is the NPV of the new plant? Assume that RC has a 35% tax rate.

Answer 1

The company's debt consist of both weight for long-term debt and a weight for accounts payable.

We can use the weight given to accounts payable to calculate the weight of accounts payable and the weight of long-term debt.

Accounts payable weight = 0.17/1+ 0.17 = 0.1453

Long-term debt weight = 1/1+ 0.17 =0.8547

Since the accounts payable has the same cost as the overall WACC, we can write the equation for the WACC as:

WACC = (1/1+ 0.75)(0.16) + (0.75/1+ 0.75)[(0.17/1+ 0.17)WACC + (1/1+ 0.17)(0.08)(1 - 0.35]

Now let us find out WACC by solving the above equation

WACC = 0.0914+ 0.4286[0.1453 WACC + 0.0444]

WACC = 0.0968 + (0.0623)WACC + 0.0190

(0.9377)* WACC = 0.1158

WACC = 0.1235 or 12.35%

Since the cash flows go to perpetuity, we can calculate the future cash inflows using the

equation for the PV of a perpetuity.

Cost = $40,000,000

PV of perpetuity = $7,600,000/0.1235= $61,538,461.54

NPV = PV of perpetuity - cost

NPV = $61,538,461.54 -$40,000,000

NPV = $21,538,461.54