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

Question

Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $1.77 million at the end of the first year, and these savings will grow at a rate of 1 percent per year indefinitely. The firm has a target debtequity ratio of .75, a cost of equity of 11.7 percent, and an aftertax cost of debt of 4.5 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 2 percent to the cost of capital for such risky projects.

what is the maximum intial cost the company would be willing to pay for the project?

Explanation / Answer

debtequity ratio =.75

weight of equity=1/(1+debtequity ratio)=1/1.75=4/7

weight of debt=1-4/7=3/7

aftertax cost of debt = 4.5%=.045

cost of equity =11.7%=.117

cost of capital=weight of equity*cost of equity + weight of debt*aftertax cost of debt +2%(adjustment factor of +2 percent to the cost of capital for such risky projects)

cost of capital=(4/7)*.117 + (3/7)*.045 +2%

cost of capital=8.614%+2% =10.614%=.10614

Savings Present value=$1.77 /(.10614-.01) million=$18.41 million

Thus  maximum intial cost the company would be willing to pay for the project is $18.41 million.

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