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 $67 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $6.8 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 12 percent. 2. A new issue of 20-year bonds: The flotation costs of the new bonds would be 2.1 percent of the proceeds. If the company issues these new bonds at an annual coupon rate of 6 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 .10. (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.) NPV

NPV

Answer 1

Solution: Step 1: calculation of WACC D/E= D/V=0.8/(1+0.8) E/V=1/(1+0.8) 0.8 0.444444444 0.555555556 0.1 B2/B1 B1/V=(B1/(B1+B2)) *D/V (1/(1+0.1))*0.44444444 0.404040404 0.040404040 B2/V=(B2/(B1+B2))*D/V (0.1/(1+0.1))*0.44444444 WACC=re* (E/V)+rB1*(B1/v)*(1-T) +r B2*(B2/v) let the WACC be 'a' a=0.12*0.55555556+0.06*0.404040404040404*(1-0.25)+a*0.04040404 a=0.066666667+0.018181818+0.04040404a a-0.04040404a=0.084848485 0.95959596a=0.084848485 a=0.084848485/0.95959596 a: 8.84210526% Step 2: calculation of WAFC WAFC=fe*(E/V)*(1-k)+fB1*(B1/V)+fB2*(B2/V) let the WAFC be 'a' a=0.073*0.55555556+0.021*0.404040404040404+0*0.04040404 a= 4.90404040% Step 3 :calculation of NPV PV of cash in flow=6800000/8.84210526% Less : Initial cash outflow=67000000/(1-0.049040404) NPV 76904761.90 -70455148.97 6449613

D/E Debt to equity ratio D/V Debt to value ratio E/V Equity to value ratio B2/B1 | Accounts payable to long term debt ratio B1/v Long term bond to value ratio B2/v Short term debt to value ratio WACC Weighted average cost of capital re cost of equity rB1 cost of long term debt rB1 cost of short term debt T Tax rate WAFC|Weighted average cost of floatation cost fe flotation cost of equity fB1 flotation cost of long term debt fB1 flotation cost of short term debt financing from retained earning k Rounded figures are shown for display purpose only but entire figure is used for actual calculation.