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 $1.86 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 debtequity ratio of .80, 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 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

WACC = Weight of Equity* Cost of Equity + Weight of Debt* After Tax cost of Debt

WACC = 1/(1+0.80) * 12.60 + 0.80/(1+0.80) * 5.4

WACC = 9.40%

Risk Adjusted Discount Rate (RADR) = WACC + adjustment factor

Risk Adjusted Discount Rate (RADR) = 9.40% + 3%

Risk Adjusted Discount Rate (RADR) = 12.40%

Maximum initial cost the company would be willing to pay for the project = initial aftertax cash savings/ (Risk Adjusted Discount Rate - growth rate)

Maximum initial cost the company would be willing to pay for the project = 1.86/(12.40%-2%)

Maximum initial cost the company would be willing to pay for the project = $ 17.8846 Million

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