Photochronograph Corporation (PC) manufactures time series photographic equipmen
ID: 2766154 • Letter: P
Question
Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debtequity ratio of 0.85. It’s considering building a new $43 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $5.5 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 7.3 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 4.0 percent of the proceeds. If the company issues these new bonds at an annual coupon rate of 7.0 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 0.20. (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
Explanation / Answer
NPV of new plant = Initial capital expenditure + after tax cash flow / rWACC
Cost of building new plant = $43,000,000
After tax cash flow perpetuity = $5,500,000
NPV of new plant = -$43,000,000 + $5,500,000 / 9.48%
NPV of new plant = -$43,000,000 + $58,016,878
NPV of new plant = $15,016,878
Step 1: Calculation of WACC
Debt equity ratio (D/E) = 0.85
Required rate of return on equity (rs) = 13%
Annual coupon rate (rB1 ) = 7%
Cost of Account payable financing (rB2) = rWACC
Tax Rate (T) = 40%
Equation:
rWACC = (Stock (S) / V) * rs + (Bond (B1) / V) * rB1 * (1-T) + (Accounts Payable (rB2) / V) * rB2
D/E = 0.85, S/V = 1 / 1.85 = 0.5405, B / V = 0.85 / 1.85 = 0.4595
B2 / B1 = 0.2, B1 / V = (1 / 1.2) * (B / V) = 0.4103, B2 / V = (0.2 / 1.2) * (B / V) = 0.0766
rWACC = 0.5405 * 13% + 0.4103 * 7% * (1-40%) + 0.0766 * rWACC
0.9234 rWACC = 0.5405 * 13% + 0.4103 * 7% * (1-40%)
0.9234 rWACC = 7.0265% + 1.7233%
0.9234 rWACC = 8.75%
rWACC = 9.48%