Photochronograph Corporation (PC) manufactures time series photographic equipmen
ID: 2751691 • Letter: P
Question
Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt-equity ratio of .66. It’s considering building a new $65.6 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $7.81 million in perpetuity. There are three financing options: a. A new issue of common stock: The required return on the company’s new equity is 15.2 percent. b. A new issue of 20-year bonds: If the company issues these new bonds at an annual coupon rate of 7.1 percent, they will sell at par. c. Increased use of accounts payable financing: Because this financing is part of the company’s ongoing daily business, 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.) Required: If the tax rate is 34 percent, what is the NPV of the new plant?
Explanation / Answer
Answer:
We can use the debt-equity ratio to calculate the weights of equity and debt. The debt of the
company has a weight for long-term debt and a weight for accounts payable. We can use the weight
given for accounts payable to calculate the weight of accounts payable and the weight of long-term
debt. The weight of each will be:
Accounts payable weight = 0.15/1.15 = 0.1304
Long-term debt weight = 1/1.15 = 0.8695
Since the accounts payable has the same cost as the overall WACC, we can write the equation for the
WACC as:
WACC = (1/1.66)(0.152) + (0.66/1.66)[(0.15/1.15)WACC + (1/1.15)(0.071)(1 – 0.34)]
Solving for WACC, we find:
WACC = 0.0916 + 0.3976[(0.15/1.15)WACC + 0.04074]
WACC = 0.0916 + (0.05186)WACC + 0.01619
(0.9481)WACC = 0.10779
WACC = 0.11369 or 11.37%
Since the cash flows go to perpetuity, we can calculate the future cash inflows using the equation for
the PV of a perpetuity. The NPV is:
NPV = –$65,600,000 + ($7,810,000/0.1137)
NPV = –$65,600,000 + $68,689,533.86 = -$3,089,533.861