Question

Hankins, Inc., is considering a project that will result in initial aftertax cash savings of $6 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 .59, a cost of equity of 13.4 percent, and an aftertax cost of debt of 5.3 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 +2 percent to the cost of capital for such risky projects. a. Calculate the required return for the project. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. What is the maximum cost the company would be willing to pay for this project? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.).

Answer 1

Solution:

a)Calculation of weight of equity and weight of debt

Debt to equity ratio=.59:1

Debt+Equity=1.59

Weght of debt(Wd)=.59/1.59

=0.3711

Weight of Equity(We)=1/1.59

=0.6289

Cost of equity(Ke)=13.4%

After Tax Cost of Debt(Kd)=5.3%

Cost of capital=Ke*We+Kd*Wd

=13.4%*.6289+5.3%*.3711

=8.42726%+1.96683

=10.39%

Thus required rate of return for the project is;

=Cost of capital+Adjustment for risky project

=10.39%+2%

=12.39%

b)Calcultion of maximum cost of the project(Po)

Po=After tax cash saving/(required rate of retun-growth rate)

=$6 million/12.39%-3%

=$63.90 million

Thus maximum cost the company would be willing to pay for this project is $63.90 million.