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 $1.89 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 12.9 percent, and an aftertax cost of debt of 5.7 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?

Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $1.89 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 12.9 percent, and an aftertax cost of debt of 5.7 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.

Explanation / Answer

cost of capital:              
       Ratio   cost    weighted cost
   Debt   0.8   5.7   4.56
   Equity   0.2   12.9   2.58
7.14

Since company adjust the cost for risk so adjusted cost of capital is = 7.14+1= 8.14

Initial capital= cash inflows/ (cost of capital - growth rate)

Initial capital = 1,890,000/ ( 0.0814 - 0.02)

Initial capital = 30,781,759

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