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 $1.88 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 debt-equity ratio of .85, a cost of equity of 12.8 percent, and an aftertax cost of debt of 5.6 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 maximum initial cost the company would be willing to pay for the project?

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Explanation / Answer

Answer:

WACC=(0.85/1.85)*5.6%+(1/1.85)*12.8%

=2.573%+6.92%

=9.493%

Project Discount rate=9.493%+2%=11.493%

PV of cash Flows =($1880000/(0.11493-0.03))

=$1880000/0.08493

=$22135876.60

So the project should only be undertaken if its cost is less than $$22135876.60

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