Och, Inc., is considering a project that will result in initial aftertax cash sa

Question

Och, 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 debt–equity 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 projects the firm undertakes; management uses the subjective approach and applies an adjustment factor of +2 per cent to the cost of capital for such risky projects. What is the maximum initial cost of company would be willing to pay for the project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

Explanation / Answer

Solution: Since Debt equity ratio is 0.85, so if equity is 1 then debt is 0.85 Calculation of Weight of Equity and Debt Particulars Item Weight Equity 1 0.54 Debt 0.85 0.46 1.85 1 Calculation of Weighted Average cost of capital (WACC) WACC = r(E) × w(E) + r(D) × w(D) WACC =(11.9*0.54)+(4.7*0.46) WACC = 8.59% Rate to be taken for discounting after adding 2 percent to the cost of capital. So Rate of discounting will be 8.59+2 = 10.59% Calculation of Present vale of cash flows from the project Year Cash flows PVF @ 10.59% PV of cash flows 1 1.79 0.9042 1.62 2 1.84 0.8177 1.50 3 1.9 0.7394 1.40 4 1.95 0.6686 1.30 5 2.01 0.6045 1.22 Total 7.05 So Company can willing to pay maximum initial cost equal to the present value of the cash flows of the project, which is 7.05 million USD or $7,050,000.

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