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

Question

Nally, Inc., is considering a project that will result in initial aftertax cash savings of $4.2 million at the end of the first year, and these savings will grow at a rate of 2.5 percent per year indefinitely. The firm has a target debt-equity ratio of .25, a cost of equity of 13.1 percent, and an aftertax cost of debt of 6.4 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 +2 percent to the cost of capital for such risky projects. If WACC is 11.76%, What is the maximum cost Nally would be willing to pay for this project?

Explanation / Answer

Risk adjusted WACC = 11.76 + 2 = 13.76%

Maximum cost to be paid for this project = [4200000/1.13761] + [4200000(1.025)/(1.1376)2]/(1- 0.025 / 0.1376)

= 3691983.12236 + 4065126.19793

= $7757109.32028

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