Nally, Inc., is considering a project that will result in initial aftertax cash
ID: 2754332 • Letter: N
Question
Nally, Inc., is considering a project that will result in initial aftertax cash savings of $6 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 .59, a cost of equity of 13.4 percent, and an aftertax cost of debt of 5.3 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.
Requirement 1: Calculate the WACC. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) WACC %
Requirement 2: What is the maximum cost Nally would be willing to pay for this project? (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)
Present value $
Explanation / Answer
Answer:1 Calculation of the WACC:
Using the debt-equity ratio to calculate the WACC, we find:
WACC = (.59/1.59)(.053) + (1/1.59)(.134)
=0.0197+0.08428
= 0.1040
=10.40%
Since the project is riskier than the company, we need to adjust the project discount rate for the additional risk. Using the subjective risk factor given, we find:
Project discount rate = 10.40% + 2.00% = 12.40%
Answer:2 We would accept the project if the NPV is positive. The NPV is the PV of the cash outflows plus the PV of the cash inflows. Since we have the costs, we just need to find the PV of inflows. The cash inflows are a growing perpetuity. If you remember, the equation for the PV of a growing perpetuity is the same as the dividend growth equation, so:
PV of future CF = $6,000,000/(.1240 – .03) = $63829787.23
The project should only be undertaken if its cost is less than $63829787.23 since costs less than this amount will result in a positive NPV.
The maximum cost Nally would be willing to pay for this project is $63829787.23
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