Question

Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt-equity ratio of .8. It’s considering building a new $77 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $6.7 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 6.2 percent of the amount raised. The required return on the company’s new equity is 11 percent.
2.	A new issue of 20-year bonds: The flotation costs of the new bonds would be 2.7 percent of the proceeds. If the company issues these new bonds at an annual coupon rate of 4 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 .10. (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 25 percent tax rate. (Do not round intermediate calculations and enter your answer in dollars, not millions, rounded to the nearest whole dollar amount, e.g., 1,234,567.)

Answer 1

We have to assess all the three financing options differently for computing NPV.

Given in question -

1. Cost of new project is $77,000,000
2. Current debt-equity ration is 0.80
3. After tax cash flows is $6,700,000 per annum

Option - 1 New issue of common stock:

Let us assume that the entire cost of the project is being financed by new issue of common stock.

Flotation costs is 6.2% of amount raised i.e. $77,000,000

Hence Flotation cost will be $4,774,000 ( tax saving on flotation cost is $1,193,500 i.e. 25%)

Required rate of return on new equity is 11%

Statement showing Net Present Value of new plant

Year	Particulars	Amount ($)         (a)	Present Value Factor @ 11%       (b)	Present Value Amount ($)   (a * b)
0	Cost of new plant	(77,000,000)	1	(77,000,000)
0	Flotation cost	(4,774,000)	1	(4,774,000)
0	Tax saving on Flotation cost	1,193,500	1	1,193,500
1 to ~	Cash flows	6,700,000	9.0909	60,909,090
NPV				(19,671,410)

Option - 2 New issue of 20-year bonds:

Let us assume that the entire cost of the project is being financed by 20-year bonds.

Flotation costs is 2.7% of amount raised i.e. $77,000,000

Hence Flotation cost will be $2,079,000 ( tax saving on flotation cost is $519,750 i.e. 25%)

Coupon rate of bonds is 4% hence after tax interest cost on bonds will be $2,310,000 ($77,000,000 * 4% * 0.75) for 20 years

In the option no required rate of return is given, we assume that the required rate of return is same as in option 1 i.e. 11% for comparing the options

Statement showing Net Present Value of new plant

Year	Particulars	Amount ($)         (a)	Present Value Factor @ 11%       (b)	Present Value Amount ($)   (a * b)
0	Cost of new plant	(77,000,000)	1	(77,000,000)
0	Flotation cost	(2,079,000)	1	(2,079,000)
0	Tax saving on Flotation cost	519,750	1	519,750
0 to 20	Interest cost	(2,310,000)	7.9633	(18,395,223)
1 to ~	Cash flows	6,700,000	9.0909	60,909,090
NPV				(36,045,383)

Option - 3 Accounts payable financing:

Since the current long tern debt is not given in question we cannot formulate the extent of accounts payable financing for the new project, now let us assume that the entire cost of the project is being financed by Accounts payable.

There will be no flotation cost incurred

In the option no required rate of return is given, we assume that the required rate of return is same as in option 1 i.e. 11% for comparing the options

Statement showing Net Present Value of new plant

Year	Particulars	Amount ($)         (a)	Present Value Factor @ 11%       (b)	Present Value Amount ($)   (a * b)
0	Cost of new plant	(77,000,000)	1	(77,000,000)
1 to ~	Cash flows	6,700,000	9.0909	60,909,090
NPV				(16,090,910)

The NPV calculated above is using 11% of required return in all the three options and the infinite cash flows are considered for all the three options.