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 $1.73 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 debtequity ratio of .85, a cost of equity of 11.3 percent, and an aftertax cost of debt of 4.1 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 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

Debt Equity Ratio = 0.85

Debt / Equity = 0.85

Debt = 0.85 Equity

Debt + Equity = 1

0.85 Equity + Equity = 1

Equity = 1/1.85 i.e 54%

Debt = 1-0.54 i.e 46%

Weighted average cost of capital = 0.54*11.3+0.46*4.1

= 7.99%

Annual Benefit = 1.73 million

Initial cost the company would be willing to pay = Annual Benefit / WACC - Growth

= 1.73/7.99%-3%

= 34.67 million

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