Photochronograph Corporation (PC) manufactures time series photographic equipmen
ID: 2752415 • Letter: P
Question
Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt-equity ratio of .63. It’s considering building a new $65.3 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $7.78 million in perpetuity. There are three financing options:
A new issue of common stock: The required return on the company’s new equity is 15.3 percent.
A new issue of 20-year bonds: If the company issues these new bonds at an annual coupon rate of 7.3 percent, they will sell at par.
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 .12. (Assume there is no difference between the pretax and aftertax accounts payable cost.)
If the tax rate is 38 percent, what is the NPV of the new plant?
Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt-equity ratio of .63. It’s considering building a new $65.3 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $7.78 million in perpetuity. There are three financing options:
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 = 0.12/1.12 = 0.1071
Long-term debt weight = 1/1.12 = 0.8928
Since the accounts payable has the same cost as the overall WACC, we can write the equation for the
WACC as:
WACC = (1/1.63)(0.153) + (0.63/1.63)[(0.12/1.12)WACC + (1/1.12)(0.073)(1 – 0.38)]
Solving for WACC, we find:
WACC = 0.0939 + 0.3865[(0.12/1.12)WACC + 0.04041]
WACC = 0.0939 + (0.04141)WACC + 0.01562
(0.95858)WACC = 0.10952
WACC = 0.11425 or 11.43%
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 = –$65,300,000 + ($7,780,000/0.1143)
NPV = –$65,600,000 + $68,066,491.69 = -$2,466,491.689