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 $6.8 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 .67, a cost of equity of 13.2 percent, and an aftertax cost of debt of 6.2 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 +1 percent to the cost of capital for such risky projects.

What is the maximum cost Nally would be willing to pay for this project?

The WACC is 10.4%.

Explanation / Answer

WACC = Wd×Rd×(1-t)+We×Ke+Risk premium

W is weights of respective portfolios

R is return on respective portfolios

Wd+We = 1

= 0.67×6.2%+1×13.2%+1%

= 18.33%

Maximum cost:

= After tax cash flows year 1÷(Required rate-Growth rate)

= $6,800,000÷(18.33%-3%)

= $44,357,469

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