Problem 13-22 Flotation Costs and NPV Photochronograph Corporation (PC) manufact
ID: 2729271 • 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
PC WACC details Details Ratio/Amt/% Target debt equity ratio=0.85/1 Required Funding 58,000,000 Target Debt =58M*0.85/1.85= 26,648,649 Target Equity = 31,351,351 Accounts Payable/LT debt=0.2/1 Target Long term debt = 22,207,207 Target funding from increased Accounts payable= 4,441,441 Equity cost Cost of new equity =13% Floatation cost =8.8% of issue proceeds effctive cost of new equity =13%/(1-8.8%)= 14.25% Bond cost Annual coupon rate =7% As at 7% the bond will sale at par, the YTM is 7% Floatation cost =4% of the proceeds. Effective bond cost =7%/(1-4%)= 7.29% Tax rate =40% Post Tax effective cost =7.29%*(1-40%)= 4.38% WACC calculation Details Value Weight of Value Post Tax cost Weighted cost Equity 31,351,351 58.54% 14.25% 8.34% Debt 22,207,207 41.46% 4.38% 1.81% Total 53,558,559 10.16% WACC of the required external funding is 10.16% Expected after tax cash flow $7 Million /Year in Pepeturity So PV of the after Tax cash flows=7000000/0.1016= $ 68,897,637.80 Less Cost Of investment= $ 58,000,000.00 NPV of the New plant = $ 10,897,637.80