Problem 14-28 Flotation Costs and NPV [LO3, 4] Photochronograph Corporation (PC)
ID: 2727609 • Letter: P
Question
Problem 14-28 Flotation Costs and NPV [LO3, 4]
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:
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.
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.
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.
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:
Explanation / Answer
Cost of equity =Required return/(100-Floatation Cost)=14/(100-7.8)=0.151 or 15.10%
Cost of Debt= Coupon/(100-Floatation Cost)=8/(100-5)=0.084 or 8.4%
After tax cost of debt=8.4*(1-0.35)=5.46
Debt/Equity=0.8
Proportion of debt=0.8/1.8=0.444
Proportion of equity=1/1.8=0.555
WACC=0.444*15.10 +0.555* 5.46=9.73
Accounts receivable is not a form of long term capital and hence ignored in the calculation.
The PV of 6m in perpetuity=6/WACC=6/0.0973=61.66
NPV=61.66-48=$13.66m