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 $1.76 million at the end of the first year, and these savings will grow at a rate of 3 percent per year indefinitely. The firm has a target debtequity ratio of .85, a cost of equity of 11.6 percent, and an aftertax cost of debt of 4.4 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 1 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?

Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $1.76 million at the end of the first year, and these savings will grow at a rate of 3 percent per year indefinitely. The firm has a target debtequity ratio of .85, a cost of equity of 11.6 percent, and an aftertax cost of debt of 4.4 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 1 percent to the cost of capital for such risky projects.

Explanation / Answer

debtequity ratio =.85

weight of equity=1/(1+debtequity ratio)=1/1.85=.54

weight of debt=1-.54=.46

aftertax cost of debt = 4.4%=.044

cost of equity =11.6%=.116

cost of capital=.54*.116+ .46*.044+1%(adjustment factor of +1 percent to the cost of capital for such risky projects)

cost of capital=0.08288+.01 = 0.09288

Savings Present value=$1.76/( 0.09288-.03) million=$27.99 million

Thus  maximum intial cost the company would be willing to pay for the project is $27.99 million.

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