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Nally, Inc., is considering a project that will result in initial aftertax cash

ID: 2766542 • Letter: N

Question

Nally, Inc., is considering a project that will result in initial aftertax cash savings of $6.8 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 .67, a cost of equity of 13.2 percent, and an aftertax cost of debt of 6.2 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.

What is the maximum cost Nally would be willing to pay for this project?

Explanation / Answer

Solution :

WACC = Kd * Wd + Ke*We

(0.068*0.67)+(0.132*.33)

8.912%

Kd = cost of debt

Ke= cost of equity

Wd/We = debt/equity weight

Risk adjusted cost of capital

(8.912%+1%)

9.912%

Present value of cashflow till infinity = cash savings/(cost of capital-growth)

   98,379,629.63

6800000/(0.0912-0.03)

hence maximum cost Nally would be willing to pay for this project

   98,379,629.63

WACC = Kd * Wd + Ke*We

(0.068*0.67)+(0.132*.33)

8.912%

Kd = cost of debt

Ke= cost of equity

Wd/We = debt/equity weight

Risk adjusted cost of capital

(8.912%+1%)

9.912%

Present value of cashflow till infinity = cash savings/(cost of capital-growth)

   98,379,629.63

6800000/(0.0912-0.03)

hence maximum cost Nally would be willing to pay for this project

   98,379,629.63