Photochronograph Corporation (PC) manufactures time series photographic equipmen
ID: 2726584 • Letter: P
Question
Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debtequity ratio of .75. It’s considering building a new $41 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $5.3 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 7.1 percent of the amount raised. The required return on the company’s new equity is 15 percent. 2. A new issue of 20-year bonds: The flotation costs of the new bonds would be 3.0 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 38 percent tax rate. (Enter your answer in dollars, not millions of dollars, e.g. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount, e.g., 32.)
Explanation / Answer
Company wants to maintain a debt equity ratio of 0.75. Thus issue of debt capital of $75 will mean equity of $100 will be issued. So out of $41 million, company will collect $41*100/175 = $23.43 million fund from equity issue.
Flotation cost of equity share is 7.1%. Thus 100 - 7.1%=92.9% of total issue value is the net fund received from new equity. If net collection from equity is $23.43 million, then actual amount of new equities issued is :-
$23.43 million * (100/92.9) =$25.22 million
If total fund requirement is $41 million and debt equity ratio is 0.75, then $41* (75/175)=$17.57 million will be collected from debt capital.
There are two sources of debt capital. First one is long term 6% bond. Second one is short term debt in the form of accounts payable. Ratio of Accounts payable to long term debt is 0.10.
$17.57 million is to be collected from debt. Out of this -
1. Amount collected from 6% 20 years bond is => $17.57 * (100 /110) => $15.97 million
2. Amount collected by increasing accounts payable is => $17.57* (10/110) => $1.60 million
Now consider 6% bond. At the time of issuing bond company has to incur flotation cost of 3%. So net fund collected from this source is 100- 3 => $96. So in order to collect $15.97 million total value of bond required to be issued is $15.97 x (100/97) = $16.46 million.
Thus for getting total fund of $41 million, company will issue-
1. Equity share of $25.22 million
2. 6%, 20 years Bond of $16.46 million and
3. By increasing accounts payable of $1.60 million.
WACC => [ ( 25.22 * 15%) + (16.46 * 6%) ] / ( 25.22 + 16.46)
WACC => 11.45%, this WACC is also applicable on the accounts payable.
After tac CAsh flow => 5.3 million
So NPV => 5.3 / 11.45%
NPV => $46.29 Million