Stranger Inc., is considering a project that will result in initial aftertax cas

Question

Stranger Inc., is considering a project that will result in initial aftertax cash savings of $ 3.5 million at the end of the first year, and these savings will grow at a rate of 5 % per year indefinitely. The firm has a target debt equity ratio of .70, a cost of equity of 13 %, and an aftertax cost of debt of 5.5 %. 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 + 2 % to the cost of capital for suck risky projects. Under what circumstances should the company take on the project?

debt equity ratio = .70
cost of equity (Re) = 13 %
after tax cost of debt (RD ) = 5.5 %

WAAC = (E/V) x Re + (D/V) x RD x (1 – TC)

PLEASE SHOW STEPS!

Explanation / Answer

Calculating the weight of debt and equity using Debt-equity ratio   We know that                                 Debt + Equity = Total value    From Debt-equity ratio           (0.70 / 1.70) + (1 / 1.70) = 1                                                   0.41 + 0.59 = 1 Therefore, the weight of debt is 41% and the weight of equity is 59% Substituting the values in the above formula, WACC = 0.59 * 0.13 + 0.41 * 0.055              = 0.0767 + 0.02255              = 0.09925 or 10% The project discount rate is 10% + 2% = 12% NPV = -Cost + PV of cash flows          = [$3,500,000 / (0.12 - 0.05)]         = $50,000,000 Therefore, the project should only be undertaken if the projects cost is less than $50 million.

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