Adds. Inc., is considering a project that will result in initial after-tax cash

Question

Adds. Inc., is considering a project that will result in initial after-tax cash savings o million at the end of the first year, and these savings will grow at a rate of 4% per year indefinitely. The find has a target debt-equity ratio of 0.7. a cost of equity of 14% and an after-tax cost of debt of 5.5%. 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% to the cost of capital of such risky projects. Under what at circumstances should Adds take on the project?

Explanation / Answer

Weights assigned to debt = .7 / (1+.7) 41.18% Weights assigned to equity = 1 / (1+.7) 58.82% Cost of debt 5.50% Cost of Equity 14.00% WACC = Wd x kd + We x ke (.4118 x .055) + (.5882 x .14) 10.50% Project discount rate would be WACC + 1% 11.500% Cash Flow $ 3,000,000 PV of Cash flow = Cash flow / ( WACC - Growth rate) 3000000 / (11.50% - 4%) $40,000,000 The project should be undertaken only if the cost of the project is less than 40million. It should be rejected in case the cost is more than 40m

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