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 $1.79 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 11.9 percent, and an aftertax cost of debt of 4.7 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. What is the maximum initial cost the company would be willing to pay for the project? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.)

Explanation / Answer

Solution :-

Weighted average cost of capital = Weight of debt * Cost of debt (after tax) + Weight of equity * Cost of equity.

= 0.85 * 4.7 % + (1 - 0.85) * 11.9 %

= 3.995 % + 0.15 * 11.9 %

= 3.995 % + 1.785 %

= 5.78 %

Adjusted cost of capital = 5.78 % + 2.00 % (Adjustment factor).

= 7.78 %

Initial cost of Project = 1.79 Million / (0.0778 - 0.03)

= 1.79 Million / 0.0478

= $ 37.447699 Million i.e., $ 37447699 (37.447699 * 1000000)

Conclusion :- Maximum initial cost of the project = $ 37447699 (approx).

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