Question

Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt-equity ratio of .79. It’s considering building a new $66.9 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $7.94 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 15.3 percent. b. A new issue of 20-year bonds: If the company issues these new bonds at an annual coupon rate of 7.2 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 .11. (Assume there is no difference between the pretax and aftertax accounts payable cost.) If the tax rate is 24 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, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

Ans.

WACC = [Re * We] + [Rd * (1−t) * Wd], where

• Re is the cost of equity,
• Rd is the cost of debt,
• t is the tax rate, and
• wi is the corresponding market weight, for example we = we / [we + wd]

Since the target Debt / Equity ratio is 0.79,

Debt represents 0.79 / 1.79 = 0.441340 or 44.1340% of the company and Equity represents the remaining 55.8660%.

Using the WACC formula,

WACC = [0.153 * 0.558660] + [0.072 * (1 - 0.24) * 0.441340] = 0.08547 + 0.02415 = 0.10962 or 10.96%

The net present value (NPV) formula for perpetual cash flows is:

NPV = −I + [CF/r]

where,

I = Initial Investment

CF = Cash Flow

r = Cost of Capital

- $ 66.9 + $ 7.94 / 0.1096 = - $ 66.9 + $ 72.4453 = $ 5.5453 or $ 5.55 million