Billy D\'s Basketball Camp is considering a project that will result in initial

Question

Billy D's Basketball Camp is considering a project that will result in initial aftertax cash savings of $3.9 million at the end of the first year, and these savings will grow at a rate of 5 percent per year indefinitely. The firm has a target debt-equity ratio of .64, a cost of equity of 15 percent, and an aftertax cost of debt of 5.9 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 discount rate that should be set for the project?

Explanation / Answer

Wd= .64 /(1+.64) = .64 / 1.64 = .39

We = 1/1.64 = .61

WACC = (After tax debt *Wd) +(Cost of equity *We)

           = ( 5.9 * .39 ) +(15 * .61)

          = 2.301+ 9.15

          = 11.451%

Discount rate = 11.451 + 2 = 13.45 % (approx)

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