n 3 (of 5) Score This Question 3. value: 10.00 points Scanlin, Inc., is consider
ID: 2794932 • Letter: N
Question
n 3 (of 5) Score This Question 3. value: 10.00 points Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $1.78 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 .80, a cost of equity of 11.8 percent, and an aftertax cost of debt of 4.6 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 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? (Enter your answer in dollars, not your answer to the nearest whole dollar amount, e.g 32.) t millions of dollars, .., 1,234,567. Do not round intermediate calculations and round Maximum cost References eBook & Resources ming Objective: 14-03 How determine a firms overall cost capital and how to use it to value a company WorksheetExplanation / Answer
Debt - Equity Ratio = Debt / Equity = 0.8 / 1
Therefore, Total value = Debt + Equity = 0.8 + 1 = 1.8
Weight of debt = 0.8 / 1.8 , Weight of equity = 1 / 1.8
Cost of capital (WACC) = After tax cost of debt x weight of debt + Cost of equity x weight of equity = 4.6% x 0.8 / 1.8 + 11.8% x 1 / 1.8 = 8.60%
Cost of capital for project would have an adjustment factor / addition of 3% as it is a risky project -
Cost of capital for project (Ke) = 8.60% + 3% = 11.60%
Now, the maximum initial cost that company would pay would be equal to the Present value of cash inflows from the project. Since, these inflows will grow indefinitely, PV will be computed as -
PV = Cash Inflows / (Ke - g) = $1,780,000 / (0.116 - 0.02) = $18,541,666.66666 or $18,541,667
where, g is the growth rate of 2%.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.