Hankins, Inc., is considering a project that will result in initial aftertax cas

Question

Hankins, Inc., is considering a project that will result in initial aftertax cash savings of $5.9 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 .58, a cost of equity of 13.3 percent, and an aftertax cost of debt of 5.2 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. Calculate the WACC What is the maximum cost the company would be willing to pay for this project?

Explanation / Answer

Calculation of weights of equity and debt to total capital:

Given debt/equity= 0.58

Debt = 0.58Equity

If total capital=1= Equity+Debt

Equity+0.58Equity=1

Equity= 63.29% of total capital and Debt= 1-63.29%= 36.71% of total capital

WACC= Cost of equity*Its weight + cost of debt*its weight= 13.3*63.29% + 5.2%*36.71%= 10.33%

After adding adjustment factor of 1%, WACC= 11.33%

Maximum cost company will pay for this project will be the present value of all cash savings:

Cash savings after 1 year(CF1)= 5.9M

Growht rate(g)= 3%

Required return(K)= 11.33%

Hence value of this investment= CF1/(K-g)= 5.9M/(11.33%-3%)= 70.86M

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