Och, Inc., is considering a project that will result in initial aftertax cash sa

Question

Och, Inc., is considering a project that will result in initial aftertax cash savings of $3.5 million at the end of the first year, and these savings will grow at a rate of 4 percent per year indefinitely. The firm has a target debtequity ratio of .55, a cost of equity of 13 percent, and an aftertax cost of debt of 5.5 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 the company would be willing to pay for the project?

Explanation / Answer

WACC = cost of common equity * Weight of common equity + After tax cost of debt * weight of debt

WACC = 13 * 1/1.55 + 5.5*0.55/1.55

WACC = 10.33871%

Risk Adjusted Cost of Capital = 10.33871 + 2 = 12.33871%

Maximum initial cost the company would be willing to pay for the project = 3500000/(0.1233871-0.04)

Maximum initial cost the company would be willing to pay for the project = $ 41,972,919

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