Scanlin, Inc., is considering a project that will result in initial aftertax cas

Question

Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $1.84 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 debtequity ratio of .75, a cost of equity of 12.4 percent, and an aftertax cost of debt of 5.2 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 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 millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.)

NO EXCEL SOLUTIONS PLEASE!!!!

Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $1.84 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 debtequity ratio of .75, a cost of equity of 12.4 percent, and an aftertax cost of debt of 5.2 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 3 percent to the cost of capital for such risky projects.

Explanation / Answer

WACC = cost of equity * equty weight + cost of debt after tax * debt weight

WACC= (.75/1.75)(.052) + (1/1.75)(.124) = 9.31%

project discount rate = wacc + adjustment factor = 9.31% + 3.00% = 12.31%

In order to calculate PV of cash flows we can use formula for growing perpetuity

PV=C/(R-g)

Growth rate g=1%.

NPV = – cost + PV cash flows;

PV = [$1.84M/(.1231 – .01)] = $ 16,268,788

The project should only be undertaken if its cost is less than $16,268,788

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