Photochronograph Corporation (PC) manufactures time series photographic equipmen
ID: 2727396 • Letter: P
Question
Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debtequity ratio of .8. It’s considering building a new $48 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $6 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 7.8 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 5.0 percent of the proceeds. If the company issues these new bonds at an annual coupon rate of 8 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 35 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
The company has capital budgeting project of building a new $48 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $6 million in perpetuity. There are three financing options:
1. A new issue of common stock
2. A new issue of 20-year bonds
3. Increased use of accounts payable financing
1) Company wants to maintain target debtequity ratio of 0.8.Thus issue of debt capital of $80 will mean issue of $100 equity. So out of $48 million company will collect $48*100/180 = $26.67 million fund from equity issue.Further it has been mention that floatation cost of equity Share is 7.8% of the amount raised. Thus 100-7.8 =92.2% of total issue value is the net fund received from new equity. If net collection from equity is $26.67 million then the actual amount of new equity issued is $26.67 million/0.922 = $28.93 million.
2) Now consider Debt amount. If total fund requirement is $48 million and debt equity ratio is 0.8 then $48*80/180 = $21.33million will be collected from debt issue. There are two source of debt capital one is issue of long term at 8% bond. Second is short term debt in the form of account payable. Ratio of account payable to debt is 0.15 which means that if $100 is collected from bond issue then $15 will be collected through accounts payable. Here $21.33million will be collected from debt out of this –
1. Amount collected from 8% 20 years bond is $21.33million*100/115 = $18.55 million
2. Amount collected from Accounts payable is $21.33million*15/115 = $2.78 million
3)Now consider to issue 8% bond company has to incur 5% floatation cost. Thus out of $100 bond $ will be paid as floatation cost. So net fund collected from this source is $100-$5 = $95.So in order to collect $18.55 million total amount of bonds require to issue is $18.55/0.95 =$19.53 million.
Thus for getting total fund of $48 million, company will issue-
1. Equity Shares of = $28.93 million
2. 8% Bonds of =$19.53 million
3. Accounts Payable =$2.78 million
4)Note that accounts payable is a part of company’s ongoing business. So calculation of cost of capital will not consider it. It has been clearly mentioned that that weighted average cost of capital(WACC) is the cost of this account payable.
WACC = ((Equity Issued *Cost of Equity) + (Debt Issued *Cost of Debt)) / ( Equity Issued+ Debt Issued)
= (($28.93 million*0.14 ) +(=$19.53 million*0.08)) / ($28.93 million+=$19.53 million)
= $5.6126/$48.46
=11.58%
This WACC also applicable to accounts payables.
5)Now consider cash inflow from this new project. It will generate cash flow of $6 million each year. Since tax rate is 35% tax rate. So net Cashflow per year = $6 million*(1-0.35) = $3.9 million. As cashflow will generate for perpetuity.
NPV of this cashflow = $3.9million /11.58% = $33.68 million
Answer: NPV of new plant is $33.68 million cashflow. As it is positive, the return from this project is more than WACC. It will add value to the project. Hence Capital Proposal project is accepted.