Och, Inc., is considering a project that will result in initial aftertax cash sa

Question

Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.9 million at the end of the first year, and these savings will grow at a rate of 1 percent per year indefinitely. The company has a target debt–equity ratio of .75, a cost of equity of 13 percent, and an aftertax cost of debt of 5.8 percent. The cost-saving proposal is somewhat riskier than the usual projects the firm undertakes; management uses the subjective approach and applies an adjustment factor of +2 percent to the cost of capital for such risky projects. What is the maximum initial cost the company would be willing to pay for the project

Explanation / Answer

Step 1: Calculation of WACC.

Particulars

Weight

Cost of Debt / Equity (%)

WACC (%)

Debt

0.75

5.8

4.35

Equity

0.25

13

3.25

WACC

7.6

Risk Adjusted factor = +2%

Risk Adjusted WACC = 9.6%

Step 2: Maximum Initial Cost of Company:

Initial After tax cash savings = $1.9 million

Growth rate = 1% indefinitely

Formula:

PV of growing perpetuity = Initial Cash savings / (Rask adjusted WACC – Growth rate)

PV of growing perpetuity = $1.9 million / (9.6% - 1%)

PV of growing perpetuity = $22.09 million

Maximum initial cost the company would be willing to pay for the project = $22.09 million

Particulars

Weight

Cost of Debt / Equity (%)

WACC (%)

Debt

0.75

5.8

4.35

Equity

0.25

13

3.25

WACC

7.6

Related Questions

Navigate

• Browse (All)
• Browse O
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.