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 $1.84 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 0.75, a cost of equity of 12.4 percent, and an aftertax cost of debt of 5.2 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 3 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?

Explanation / Answer

debt equity ratio =0.75

debt +equity =1

0.75 * equity + equity =1

equity = 4/7

WACC = 4/7 * 12.4% + 3/7 * 5.2% = 9.31%

project discount rate = 9.31% + 3% =12.31%

PVof cash flows=(1840000/0.1231-0.01) = 16268788.68

NPV should be positive for the company toaccept the project

hence the maximum initial cost = 16268788.58

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