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 $1.72 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 11.2 percent, and an aftertax cost of debt of 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?

Explanation / Answer

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

WACC = 1/(1+0.80) * 11.2 + 0.8/(1+0.80) *4

WACC = 8%

Risk Adjusted Discount Rate = WACC + Additional Risk premium

Risk Adjusted Discount Rate = 8% + 1%

Risk Adjusted Discount Rate = 9%

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

Maximum initial cost the company would be willing to pay for the project = 1.72/(9%-2%)

Maximum initial cost the company would be willing to pay for the project = $ 24.57 Million or $ 24,571,428.57

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

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