Och, Inc., is considering a project that will result in initial aftertax cash sa

Question

Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.90 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 debt–equity ratio of .75, a cost of equity of 13.0 percent, and an aftertax cost of debt of 5.8 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 per cent to the cost of capital for such risky projects.

What is the maximum initial cost of company would be willing to pay for the project?

Explanation / Answer

D/E = 0.75

(D/A)/(D/E) = 0.75

(D/A) = 0.75 * (1 - D/A)

D/A = 0.4285

E/A = 1 -D/A = 1 - 0.4285 = 0.5714

WACC = D/A * after tax cost of debt + D/E * cost of equity + adjustment factor

= 0.4285 * 5.8 + 0.5714*13 + 2 = 11.9138%

Max initial cost = 1st year after tax saving /( WACC - growth rate)

= 1.9/(0.119138 - 0.01) = 17.40915m

WACC =

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