Problem 13-22 Flotation Costs and NPV Photochronograph Corporation (PC) manufact
ID: 2729255 • Letter: P
Question
Problem 13-22 Flotation Costs and NPV Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debtequity ratio of .85. It’s considering building a new $58 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $7 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 8.8 percent of the amount raised. The required return on the company’s new equity is 13 percent. 2. A new issue of 20-year bonds: The flotation costs of the new bonds would be 4 percent of the proceeds. If the company issues these new bonds at an annual coupon rate of 7 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 .20. (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 40 percent tax rate. (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount.) NPV $
Explanation / Answer
1,88,38,639
Therefore net present value is $ 1,88,38,639 cash flow. As it is positive, the return from this project is more than WACC.
Answer: Amount in $ Cost of New Building = 5,80,00,000.00 Project will generate cash flow = 70,00,000.00 for perpetuity This project will be finance from three sources. They are: a) New issue of equity b) 7%, 20 years bonds c) By increasing accounts payables Company wants to maintain debt equity ratio is 0.85 Debt equity ratio = Debt / equity 0.85 = Debt / Equity Debt = 0.85 * Equity Debt + Equity = 5,80,00,000.00 0.85 * Equity + Equity = 5,80,00,000.00 Equity = 3,13,51,351.35 Debt = 3,13,51,351.35 * 0.85 Debt = 2,66,48,648.65 Further it has been mentioned that floation cost of equity share is 8.8 % So, Total amount of equity issued = 3,13,51,351.35/91.2*100 = 3,43,76,481.74 There are two source of debt capital. First one is 7 % bond. Second one is short term debt in the form of accounts payable. Ratio of accounts payable to long term debt is 0.20 i.e Accounts payable = 0.20 * Total amount of bond = 0.20 * 2,66,48,648.65 = 53,29,729.73 Long term Bond = 2,66,48,648.65-53,2,729.73 = 2,61,15,918.92 Further it has been mentioned that floation cost of bond is 4 % Thus 100-4 = 96 % of Total issue value of the net fund received from bond So, Total amount of Bond issued = 2,61,15,918.92/96*100 = 2,72,04,082.21 Thus for getting total fund of $ 5,80,00,000.00, company will issue a) New issue of equity = 3,43,76,481.74 b) 7%, 20 years bonds = 2,72,04,082.21 c) By increasing accounts payables = 53,29,729.73 Note that accounts payable is a part of companys ongoing business. So calculation of cost of capital will not consider it. It has been clearly mentioned that weighted average cost of capital (WACC) is the cost of this accounts payable. Cost of equity here is 13% and cost of bond is 7%. Thus Calculation of weighted average cost of capital is- WACC = Equity issued * cost of equity + Debt Issued * Cost of debt * (1 - Tax rate) Equity Issued + Debt issued WACC = 3,43,76,481.74 * 13 % + 2,72,04,082.21 * 7% (1 - 40%) 3,43,76,481.74 + 2,72,04,082.21 = 56,11,514.08 6,15,80,563.95 = 9.11% This WACC is also applicable on the accounts payable. Now consider cash inflow from this new project. It will generate cash flow after tax of $70,00,000 million in each year. Since tax rate is 40% net cash inflow per year is- = 70,00,000/9.11% = 7,68,38,638.86 NPV = Net Cash inflow - Net cash outflow = 7,68,38,638.86 - 5,80,00,000 = 1,88,38,638.86 =1,88,38,639
Therefore net present value is $ 1,88,38,639 cash flow. As it is positive, the return from this project is more than WACC.
It will add value to the project. Hence capital project proposal is accepted