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 $1.76 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 11.6 percent, and an aftertax cost of debt of 4.4 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 +1 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? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

Explanation / Answer

Weighted Average Cost of Capital = Weight of Debt * After Tax Cost of Debt + Weight of Equity * Cost of Equity

                                                       = 0.85/1.85 * 4.4 + 1/1.85 * 11.6 = 8.29%

Appropriate Discount Rate = Weighted Average Cost of Capital + Adjustment Factor = 8.29 + 1 = 9.29%

After Tax Cash Saving in year 1 = $1,760,000

Growth Rate in Cash Savings = 3%

Maximim initial cost of company would be willing to pay for the project

              = Cash savings in year 1/(Appropriate Discount Rate - Growth Rate in Cash Savings)

              = 1,760,000/(9.29% - 3%) = 1,760,000/0.0629 = $27,972,508.59

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