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 $1.87 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 debt–equity ratio of 0.75, a cost of equity of 12.7 percent, and an aftertax cost of debt of 5.5 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 2 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

Calculation of WACC (Cost of Capital):

Cost of Capital = 9.61%

Adjustment Factor = 2%

Adjusted Cost of Capital = 9.61 + 2 = 11.61%

Maximum Initial Cost the company is willing to pay

= Present Value of all Future Cash Flows

= Cash Savings at the end of year 1 / ( Adjusted Cost of Capital - Growth Rate)

= $1.87 million / (11.61% - 1%)

= $1.87 million / 10.61%

= $17.6248 million

Maximum Amount that the company is willing to pay initially = $17.6248 million

Formula Explanation:

It is as same as Gordons Formula

i.e., Present Value (Market Value) = Dividend (Cash Inflow) / (Cost of Capital - Growth Rate)

Here Dividend is substituted with Cash Savings as they are the cash inflows

Type of Capital Cost Weight Weight * Cost Debt 5.5% 0.42857 (0.75/1.75) 2.357135% Equity 12.7% 0.57143(1/1.75) 7.257161% 1 9.614296%

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