Nally. Inc . is considering a project that will result in initial aftertax cash

Question

Nally. Inc . is considering a project that will result in initial aftertax cash savings of $6.7 million at the end of the first year, and these savings will grow at a rate of 3 percent per year indefinitely. The firm has a target debt equity ratio of 66, a cost of equity of 13.1 percent and an aftertax cost of debt of 6. 1 percent The cost-saving proposal is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and applies an adjustment factor of +3 percent to the cost of capital for such risky projects. Requirement 1: Calculate the WACC (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) WACC Requirement 2: What is the maximum cost Nalty would be willing to pay for this project? (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g.. 32.16).) Present value

Explanation / Answer

Requirement 1:

WACC = (Cost of equity x weightage of equity) + (Cost of debt x weightage of debt)

= (13.1 x 0.6) + (6.1 x 0.4)

= 10.30%

Note:

Debt equity ratio = Debt / Equity

0.66 = Debt / Equity

2/3 equity = Debt

or

Equity = 1.5 x Debt

Total capital = Equity + Debt

= 1.5 Debt + Debt

= 2.5 Debt

Which means 40% is the weightage of Debt and 60% is the weightage of equity.

Requirement 2:

WACC of new project = WACC + risk adjustment

= 10.30 +3.00

= 13.3%

Maximum cost Nally willing to pay = Cash flow @t=1 / (Adjusted WACC - growth of the new project)

= (6,700,000 x 1.03) / (0.133 - 0.030)

= $67,000,000

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