Question

Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.88 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 .85, a cost of equity of 12.8 percent, and an aftertax cost of debt of 5.6 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.)

Answer 1

22.14 billion

Step-by-step explanation:

First, we will calculate the WACC where,

• WACC = we x ke + wd x kd x (1 - tax)

• And Weight of Equity = E/(D+E) = 1 / 1.85 = 54%
• The weight of debt = 1 - 54% = 46%

• The cost of equity = 12.8%
• the cost of debt = 5.6%
• WACC = 54% * 12.8% + 46% x 5.6% = 9.49%

The WACC for the project will be 9.49 + 2 = 11.49% as the project is riskier.

As the after tax cash savings are expected to grow at a constant rate indefinitely, it is a perpetuity,

V of perpetuity = 1.88m / (11.49% - 3%) =$22.14

This (22.14) is the maximum that the company can invest as initial cost as at this initial investment, the present value of the project will be zero.