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 $1.89 million at the end of the first year, and these savings will grow at a rate of 2 percent per year indefinitely. The firm has a target debt–equity ratio of 0.80, a cost of equity of 12.9 percent, and an aftertax cost of debt of 5.7 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 1 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? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount.)

Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $1.89 million at the end of the first year, and these savings will grow at a rate of 2 percent per year indefinitely. The firm has a target debt–equity ratio of 0.80, a cost of equity of 12.9 percent, and an aftertax cost of debt of 5.7 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 1 percent to the cost of capital for such risky projects.

Explanation / Answer

The initial cash saving at the end of year 1 ( D1)= 1.89 million$ Growth rate in annual savings(g) = 2% Given Debt equity ratio = 0.8 So Debt /Equity = 0.8 let x be debt ratio & y be 1-x then X+y =1 ==> x/(1-x) = 0.8 ==> x= 0.8-0.8x ==> x = 0.8/1.8 = 0.444444 or 8/18 y = 0.555556 or 10/18 normal cost of capital = (12.9%*10/18)+(5.7*8/18)= 9.7% Riskier cost of capital for project (k) = 9.7%+1% = 10.7& As per gordon model Present value of funds = D1/k-g = 1.89 million/(10.7%-2%) = $ 21.7241 million So the maxiumum out flow of funds should be equal to project inflows present value Hence the maximum outflow = $ 21.72 million

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