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 $1.87 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 debt–equity ratio of .75, a cost of equity of 12.7 percent, and an aftertax cost of debt of 5.5 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 per cent to the cost of capital for such risky projects.

What is the maximum initial cost of company would be willing to pay for the project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

Explanation / Answer

1) WACC of the firm = 5.5*0.75/1.75 + 12.7*1/1.75 = 9.61%

Risk adjusted discount rate for the project = 9.61 + 2.00 = 11.61%

2) Initial cost that can be paid for the project = 1.87/1.1161 (PV of the 1st year cash flow) + [(1.87*1.01)/(0.1161 - 0.01)]/1.1161 (terminal value of 1.87*1.01/(0.1161 - 0.01) discounted at 11.61%)

= 1.675477 + 15.949405 = $17,624,882.

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