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 $1.74 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 .75, a cost of equity of 11.4 percent, and an aftertax cost of debt of 4.2 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 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? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars (e.g, 1,234,567). Round your answer to 2 decimal places (e.g., 32.16).)

Explanation / Answer

Step1 : Calculation of Adjusted WACC

WACC = 1/(1+debt-equity ratio) * cost of equity + debt-equity ratio/(1+debt-equity ratio) * aftertax cost of debt

WACC = 1/(1+0.75) * 11.4 + 0.75/(1+0.75)*4.2

WACC = 58.20%/7

Adjusted WACC = WACC + adjustment factor

Adjusted WACC = 58.20%/7 + 2

Adjusted WACC = 72.20%/7

Step1 : Calculation of maximum initial cost

Maximum initial cost =  Annual aftertax cash savings/(Adjusted WACC - growth rate)

Maximum initial cost = 1740000/(72.20%/7 - 1%)

Maximum initial cost = $ 18,680,981.60

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