Och, Inc., is considering a project that will result in initial aftertax cash sa
ID: 2629631 • Letter: O
Question
Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.86 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 .8, a cost of equity of 12.6 percent, and an aftertax cost of debt of 5.4 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 +3 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?
Maximum cost?
Explanation / Answer
True North, Inc. is considering a project that will result in initial after-tax cash savings of $6
million at the end of the first year, and these savings will grow at a rate of 5 percent per year
indefinitely. The firm has a target debt-equity ratio of .5, a cost of equity of 10 + A percent,
and an after-tax cost of debt of 6 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 investment that True North would be willing to pay for this project?
Solution :
Target D/E of 0.8 means weight debt = 0.3333, weight equity = 0.6667
if you really mean cost of equity is 14%...
WACC = 0.3333(0.06) + 0.6667(0.14) = 0.113336..now add the risk premium of 0.02 = 0.133336 is the discount rate for the project, aka adjusted WACC...(g=growth rate)
Value = OpFreeCashFlow@t=1 / (adjustedWACC - g)
OFCF1 = OFCF(1+g) = $6mil(1.05) = 6,300,000
Value= 6,300,000 / (0.133336 -0.05) = $75,597,580.88<max T.N. should be willing to pay
Note: this answer will vary based on how many decimal places you use for the adjusted WACC.
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