Nally, Inc., is considering a project that will result in initial aftertax cash
ID: 2755502 • Letter: N
Question
Nally, Inc., is considering a project that will result in initial aftertax cash savings of $5.9 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 .58, a cost of equity of 13.3 percent, and an aftertax cost of debt of 5.2 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.
Calculate the WACC. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)
What is the maximum cost Nally would be willing to pay for this project
Nally, Inc., is considering a project that will result in initial aftertax cash savings of $5.9 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 .58, a cost of equity of 13.3 percent, and an aftertax cost of debt of 5.2 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
Requirement 1:
We have:
Kd = 5.20%
Ke = 13.30%
Wd = D/E ratio /(1+D/E ratio)
= 0.58/(1+0.58)
= 0.3671
We = 1 /(1+D/E ratio)
= 1/ (1+0.58)
= 0.6329
WACC= (We x Ke) + (Wd x Kd)
= (0.6329 x13.30%) + (0.3671 x 5.20%)
= 8.41757% +1.90892%
=10.33%
Requirement 2:
Maximum cost = WACC + risk premium
= 10.33% +1%
=11.33%
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