Question

Photochronograph Corporation (PC) manufactures time-series photographic equipment. It is currently at its target debt? equity ratio of .65. It’s considering building a new $58 million manufacturing facility. This new plant is expected to generate after-tax cash flows of $4.9 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 6.5percent of the amount raised. The required return on the company’s new equity is 10 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 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 .10. (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 PC has a 21 percent tax rate.

NPV $

Answer 1

A B C D F G Flotation cost (r) Weights Weighted cost 1 Pre-tax cost of debt 4.00% 2 2.10% 1.91% Long-term debt 0.9091 0.00%0.0909 After-tax cost of debt Accounts payable 3 0.00% 3.16% 4 Required return on new equity Total debt 5 10% 1.0000 6 7 Flotation cost of debt 1.91% Flotation cost (r Weights Weighted cost 9 1.91% 0.3939 10 Debt 0.75% 11 Equity 6.50% 0.6061 3.94% 12 Total debt 13 1.0000 14 Weighted flotation cost 15 4.69% 16 17 Initial cost 60,854,987 18 19 WACC 7.46% 20 $4,833,690 21 NPV

A E Flotation cost (r) 0,04 1 Weights - 1/1.1 Weighted cost Pre-tax cost of debt 2 Long-term debt 3 Accounts payable 0 0.021 -C2* B2 After-tax cost of debt -0.1/1.1 =G1 * (1-21 %) -С3*ВЗ 4 Required return on new equity 0.1 =SUM(C2:C4) 5 Total debt 6 HSUM(D2:D3) 7 Flotation cost of debt 8 Flotation cost (r) 9 Weights -0.65/1.65 - 1/1.65 Weighted cost 10 Debt =C10* B10 -D7 11 Equity =C11* B11 0.065 12 13 -SUM(C10:C12) Total debt 14 H SUM(D10:D11) 15 Weighted flotation cost 16 17 Initial cost =58000000/(1-D15) 18 19 WACC -[с11*65+с10*с2*G3)/(1-с10*сз) 20 =4900000/B19-B17 21 NPV