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 $1.84 million at the end of the first year, and these savings will grow at a rate of 1 percent per year indefinitely. The firm has a target debtequity ratio of .75, a cost of equity of 12.4 percent, and an aftertax cost of debt of 5.2 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?

Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $1.84 million at the end of the first year, and these savings will grow at a rate of 1 percent per year indefinitely. The firm has a target debtequity ratio of .75, a cost of equity of 12.4 percent, and an aftertax cost of debt of 5.2 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.

Explanation / Answer

CALCULATION OF MAXIMUM INITIAL COST COMPANY WOULD BE WILING TO PAY FOR THE PROJECT:

INITIAL AFTER TAX CASH SAVINGS=$1.84 MILLION

GROWTH RATE=1%

DEBT EQUITY RATIO=0.75 I.E DEBT=0.75 AND EQUITY =1 TOTAL=1.75

WEIGHT OF DEBT=0.75/1.75=0.4286

WEIGHT OF EQUITY=1/1.75=0.5714

COST OF EQUITY=12.4%

AFTER TAX COST OF DEBT=5.2%

WEIGHTED AVERAGE COST OF CAPITAL=WEIGHT OF DEBT*AFTER TAX COST OF DEBT+WEIGHT OF EQUITY*COST OF EQUITY

=5.2%*0.4286+12.4%*0.5714

=9.31%

COST OF CAPITAL AFTER APPLYING ADJUSTMENT FACTOR OF 3%=9.31%+3%=12.31%

MAXIMUM INITIAL COST COMPANY WOULD BE WILLING TO PAY

=SAVINGS/(COST OF CAPITAL-GROWTHRATE)

=$1.84MILLION/(0.1231-0.01)

=$1.84MILLION/0.1131

=$16.27 MILLION

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