Scanlin, Inc., is considering a project that will result ininitialaftertax cash

Question

Scanlin, Inc., is considering a project that will result ininitialaftertax cash savings of $1.87 million at the end of thefirstyear, and these savings will grow at a rate of 1 percent peryearindefinitely. The firm has a target debt-equity ratio of 0.75,acost equity of 12.7 percent, and an aftertax cost of debt of5.5percent. The cost saving proposal is somewhat riskier thantheusual project the firm undertakes; management uses thesubjectiveapproach and applies an adjustment factor of 2 percent tothe costof capital for such risky projects.

Explanation / Answer

Compute the WACC and adjusted WACC: Source of Weight After-tax Weighted capital cost of capital cost of capital Debt 0.4286 5.50% 2.36% Equity 0.5714 12.70% 7.26% WACC 9.61% Risk-adjusted WACC = 9.61% + 2.00% Risk-adjusted WACC = 11.61% Compute the maximum initial cost of the project which is equal to the present value of the perpetual cash flows at constant growth rate: Maximum initial cost = $1,870,000 0.1161 - 0.01 Maximum initial cost = $1,870,000 0.1061 Maximum initial cost = $17,624,882

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