Question

Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt-equity ratio of .7. It’s considering building a new $65 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $7.7 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 7.3 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 2.8 percent of the proceeds. If the company issues these new bonds at an annual coupon rate of 4 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 23 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

Cost of equity (ke) = 14%

Cost of debt (kd) = 4% (equal to annual coupon rate as it is selling at par value)

Cost of A/C payable (kac) = wacc

Let total equity be E and total debt (D) = debt in the form of bonds + A/C payable = LTD + AP

AP/LTD = 0.15 so AP = 0.15LTD

D = LTD + 0.15LTD = 1.15LTD

D/E = 0.7 so E/V = 1/(1+0.7) = 0.5882

D/V = 1-0.5882 = 0.4118

D = LTD + AP

D/V = LTD/V + AP/V

0.4118 = LTD/V + 0.15LTD/V, so LTD/V = 0.4418/(1+0.15) = 0.3581

AP/V = 0.4418 - 0.3581 = 0.0537

wacc = (weight of equity*cost of equity) + (weight of long-term debt*cost of long-term debt*(1-Tax rate)) + (weight of A/C payable*cost of A/C payable)

wacc = 0.5882*14% + (0.3581*4%*(1-23%)) + (0.0537*wacc)

1.0537wacc = 9.3381%

wacc = 8.8621%

Weighted average flotation cost (FC) = (weight of equity*flotation cost for equity) + (weight of debt*flotation cost for debt)

= (0.5882*7.3%) + (0.3581*2.8%) = 5.2967%

PV of future cash flows = perpetual cash flow/wacc = 7.7/8.8621% = 86,886,503.07

If flotation costs are ignored then NPV = PV - initial investment = 86,886,503.07 - 65,000,000 = 21,886,503.07 or 21,886,503

If flotation costs are included then NPV = PV - (initial investment/(1-FC)) =

86,886,503.07 - (65,000,000/(1-5.2967%)) = 18,251,109.19 or 18,251,109