Och, Inc., is considering a project that will result in initial aftertax cash sa
ID: 2767450 • Letter: O
Question
Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.87 million at the end of the first year, and these savings will grow at a rate of 1 percent per year indefinitely. The firm has a target debt–equity ratio of .75, a cost of equity of 12.7 percent, and an aftertax cost of debt of 5.5 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 +2 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
Step 1: Calculation Risk Adjusted WACC
Particulars
Weights
Cost of equity or debt (%)
WACC
Debt
0.75
5.5
4.125
Equity
0.25
12.7
3.175
WACC
7.3
Risk adjusted factor
2%
Risk adjusted WACC
9.3
Step 2: Present Value of Cash flows:
Initial After tax cash savings = $1,870,000
Growth rate = 1%
Present value of cash saving = Initial cash savings / (Risk adjusted WACC – Growth rate)
Present value of cash saving = $1,870,000 / (9.3% - 1%)
Present value of cash saving = $1,870,000 / 8.3%
Present value of cash saving = $22,530,120
The maximum initial cost for the project = $22,530,120
Step 1: Calculation Risk Adjusted WACC
Particulars
Weights
Cost of equity or debt (%)
WACC
Debt
0.75
5.5
4.125
Equity
0.25
12.7
3.175
WACC
7.3
Risk adjusted factor
2%
Risk adjusted WACC
9.3
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