Och, Inc., is considering a project that will result in initial aftertax cash sa
ID: 2777202 • Letter: O
Question
Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.75 million at the end of the first year, and these savings will grow at a rate of 2 percent per year indefinitely. The firm has a target debt-equity ratio of .8, a cost of equity of 11.5 percent, and an aftertax cost of debt of 4.3 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 +3 percent to the cost of capital for such risky projects. What is the maximum initial cost the company would be willing to pay for the project?
Explanation / Answer
WACC = Cost of equity * weight of equity in capital structure + After tax cost of debt * weight of debt in capital structure
D/E = 0.8
weight of equity in capital structure = E/(D + E) = 1/(1 + 0.8) = 1/1.8
weight of debt in capital structure = D/(D +E) = 0.8/(1+ 0.8) = 0.8/1.8
WACC = 11.5 *1/1.8 + 4.3 * 0.8/1.8
= 8.3%
management uses the subjective approach and applies an adjustment factor of +3 percent to the cost of capital for such risky projects
There fore discount rate for project = 8.3 + 3 = 11.3%
Initial cost should be such that NPV is >= 0
NPV = Present value of cash flows - initial investment outlay
0 = initial aftertax cash savings/(discount rate - growth rate) - initial investment outlay
initial investment outlay = 1.75/(.113 - .02)
= $ 18.8172043 m
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