Scanlin, Inc., is considering a project that will result in initial cash savings

Question

Scanlin, Inc., is considering a project that will result in initial cash savings of $2.7 million at the end of the first year, and these savings will grow at a rate of 4 percent per year indefinitely. The firm has a target debt-equity ratio of 0.90, a cost of equity of 13 percent, and a cost of debt of 4.8 percent. The cost-savings proposal is somewhat riskier than the usual project 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 will be the maximum initial cost such that the company should take on the project? Assume no taxes and depreciation.

Explanation / Answer

Debt equity ratio 90% 90% =Debt/Equity Equity*90%= Debt Total Assets =Debt+equity Total Assets =0.90 Equity+Equity Total Assets =1.90 Equity Equity= 1/1.90 Equity= 0.526316 Debt= =0.526316*90% Debt= 0.473684 Type of capital Weight Cost Cost*weight Debt 0.526316 4.80% 2.53% Equity 0.473684 13% 6.16% 1 8.68% Risk Adjusted Cost of capital =8.68%+2% 10.6800% Saving at year end 2.7 Growth every year 4% Cost of project =2.7/(10.68%-4%) 40.41916 So maximum initial cost which is acceptable is 40.42 million

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