Photochronograph Corporation (PC) manufactures time series photographic equipmen
ID: 2788517 • Letter: P
Question
Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt–equity ratio of .65. It’s considering building a new $65.5 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $7.8 million in perpetuity. There are three financing options:
A new issue of common stock: The required return on the company’s new equity is 15.1 percent.
A new issue of 20-year bonds: If the company issues these new bonds at an annual coupon rate of 7 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 .10. (Assume there is no difference between the pretax and aftertax accounts payable cost.)
If the tax rate is 35 percent, what is the NPV of the new plant? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Round your answer to 2 decimal places, e.g., 32.16.)
Note: Answer is none of the following:
- $4,267,441.86
- $6,959,076.39
- $5,800,000
Explanation / Answer
The target debt equity ratio is already given = 0.65
Now within the debts, it has 0.10 weight for Accounts Payable. Let us first try to find out the weights ratio among the long term debts and accounts payable.
Accounts Payable Weight = 0.10/1.10 = 0.090909
Long Term Debt Weight = 1/1.10 = 0.909091.
Also the cost of debt of Accounts Payable is said to be the same as the overall WACC, we can find the cost of accounts payable by calculating for WACC.
WACC = Wac*Cac+Wltd*Cltd(1-t)+We*Ce
Where:
Wac = Weight of Accounts Payable = 0.
Cac = Cost of Accounts Payable
Wltd = Weight of Long term debt
Cltd = cost of Long term debt
We & Ce = Weight of Equity and Cost of Equity
Now,
WACC = 0.65/1.65[(0.10/1.10 * WACC)+(1/1.10*0.07 (1-0.35)] + 1/1.65 * 0.151
WACC = 0.65/1.65[(0.090909WACC)+ 0.041364 ] + 0.0951515
WACC = 0.393939(0.090909WACC+0.041364)+0.0951515
WACC = 0.035813WACC+ 0.016295+ 0.0951515
WACC - 0.035813 WACC = 0.111446
0.964187 WACC = 0.111446
WACC = 0.111446/0.964187 = 0.115585 0r 11.56%
NPV = -CF0+CFn/r
Since the company is expecting to generate a cash flow of $7.8million till perpetuity, and cost of fund is 11.56%
NPV = - $65.5 million + $7.8million/0.1156
= - $ 65.5 million + $ 67.48 million
NPV = $ 1.982805 Million or in dollars it is $ 1,982,805