Question

Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.72 million at the end of the first year, and these savings will grow at a rate of 2 percent per year indefinitely. The company has a target debt–equity ratio of .8, a cost of equity of 11.2 percent, and an aftertax cost of debt of 4 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 +1 percent to the cost of capital for such risky projects.

What is the maximum initial cost the company would be willing to pay for the project? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Component	Cost	Capital	Weight	Cost * Weight
Debt	4.00%	0.80	44.44%	1.78%
Equity	11.20%	1.00	55.56%	6.22%
		1.80	WACC	8.00%
WACC	8.00%
Risk Adjustment factor	1.00%
Required rate of return	9.00%
After tax cash flow	1.72
Required rate of return	9%
Growth rate	2%
PV of all future cash flows	1.72/(9%-2%)
PV of all future cash flows	24.57
So company will be willing to pay maximum 24.57 million for the same