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 $1.7 million at the end of the first year, and these savings will grow at a rate of 3 percent per year indefinitely. The company has a target debt–equity ratio of .85, a cost of equity of 11 percent, and an aftertax cost of debt of 3.8 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 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? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Explanation / Answer

Target debt equity ratio = 85%

Proportion of equity in capital structure = 54.05%

Proportion of debt in capital structure = 45.95%

Cost of equity = 11%

After tax Cost of debt = 3.8%

Now calculate WACC Ochs, Inc. as calculated below:

WACC = 54.05% × 11% + 45.95% ×3.8%

             = 5.995% + 1.75%

             = 7.745%

Hence, WACC Ochs, Inc. is 7.745%.

Management adjust such risky project by Adding 2% in WACC.

So initial maximum cost for company = 7.745% + 2%

                                                               = 9.745%

Hence, initial maximum cost for company 9.745%.

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