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 $2.7 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 debt-equity ratio if .90, a cost of equity of 13 percent, and an aftertax cost of debt of 4.8 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. Under what circumstances should the company take n the project?

Explanation / Answer

Yes. When you invest below your cost of capital, then it is called "value destruction". Financial theory states that companies should invest in any and all projects that are NPV positive, starting with the highest return projects. They should stop investing when the NPV positive projects disappear. If no positive NPV projects can be found, then capital should be returned to shareholders either through dividends, share cancellation or share repurchase. Algebraically, NPV = PV of CF discounted at WACC. If the CF is not high enough compared to WACC, the PV is going to be lower than the $50m. In other words, you shouldn't do it.

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.