Question

Sommer, Inc., is considering a project that will result in initial after tax cash savings of $1.83 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 12.3 percent, and an aftertax cost of debt of 5.1 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 1 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

Answer 1

$22,592,593

Step-by-step explanation:

For the computation of maximum initial cost first we need to follow some steps which are shown below:-

Let equity be 1 so debt = 1 × 0.80

= 0.80

weight of debt = 0.80 ÷ 1.8

= 0.44444

weight of equity = 1 ÷ 1.8

= 0.55556

Now

Cost of capital = (After tax cost of debt × Weight of debt) + (Cost of equity × Weight of equity)

= (5.1 × 0.44444) + (12.3 × 0.55556)

= 2.266644 + 6.833388

= 9.10 %

And,

Adjusted cost of capital is

= 9.1 + 1

= 10.1%

Maximum amount willing to pay = CF1 ÷ (Adjusted cost of capital -G)

= $1,830,000 ÷ (0.101 - 0.02)

= $1,830,000 ÷ 0.081

= $22,592,593