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.

Answer 1

Since this Ratio of Debt to Equity is .85 and the required Finance is $62 million , So Equity portion comes to $33.5 million (62/1.85). Remaining portion goes to Debt which is $28.50 million.

Since accounts payable to long term debt ratio is 0.15, So Accounts Payable portion comes to $3.71 million (28.50/1.15 X .15) and Long term Debt portion comes to 24.79 (28.50/1.15).

Flotation Cost on Equity Issue (after Tax benefit on Expense) is 6.9 % of $33.5 million X (1-25%) which is $1.73 million

Flotation Cost on Debt Issue (after Tax benefit on Expense) is 2.5% of $ 24.79 million which is $0.47 Million.

Net revenue expected from this project every year is $7.4 million.

Total Investment including Flotation Cost ( $62 million + $1.73 million + $0.47 million) = $64.2 million.

After Tax cost of Debt = 7 X (1-25%) = 5.25 %

WACC (Weighted Average cost of capital) = (28.50/62 X 14) + 24.79/62 X 5.25) + (3.71/62 X 14) = 9.37 %

Annuity Factor for 20 years @9.37% would be 8.89.

So Discounted cash Inflows = $65.79 million

Cash Outflow as calculated above = $64.2 million

Net present value ($65.79 million - $64.2 million) = $1.59 million.