Question

Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt-equity ratio of .85. It’s considering building a new $62 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $7.4 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 6.9 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 7 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 25 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: Calculate 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

Long Term Debt Weight = 1/1.15

_____

Step 2: Calculate WACC

The value of WACC is arrived with the use of following formula:

WACC = 1/(1+Target Debt-Equity Ratio)*Required Return on Equity + Target Debt to Equity Ratio/(1+Target Debt to Equity Ratio)*[Accounts Payable Weight*WACC + Long Term Debt Weight*Cost of Debt*(1-Tax Rate)]

Substituting values in the above formula, we get,

WACC = 1/(1+.85)*(14%) + .85/(1+.85)*[.15/1.15*WACC + 1/1.15*7%*(1-25%)]

WACC = 0.0757 + 0.4595*[0.1304*WACC + 0.04565]

Solving further, we get,

WACC = 0.0757 + 0.05993*WACC + 0.02098

WACC - 0.05993*WACC = 0.09665

WACC = 0.09665/(1-0.05993) = 10.28%

_____

Step 3: Calculate Weight Average Flotation Cost

The value of weighted average flotation cost is calculated as follows:

Weighted Average Flotation Cost = 1/(1+Target Debt-Equity Ratio)*New Common Stock Flotation Cost + Target Debt to Equity Ratio/(1+Target Debt to Equity Ratio)*[Accounts Payable Weight*Accounts Payable Flotation Cost + Long Term Debt Weight*Debt Flotation Cost]

Substituting values in the above formula, we get,

Weighted Average Flotation Cost = 1/(1+.85)*(6.9%) + .85/(1+.85)*[.15/1.15*0 + 1/1.15*2.5%]

Solving further, we get,

Weighted Average Flotation Cost = 0.0373 + 0.0100 = 4.73%

_____

Step 4: Calculate NPV

The net present value is arrived as below:

NPV = -Amount to be Raised + Aftertax Cash Flows/WACC

Substituting values in the above formula, we get,

NPV = -62,000,000/(1-4.73%) + 7,400,000/10.28% = $6,898,472 (answer)

_____

Notes:

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