Question

Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.89 million at the end of the first year, and these savings will grow at a rate of 2 percent per year indefinitely. The firm has a target debt–equity ratio of .8, a cost of equity of 12.9 percent, and an aftertax cost of debt of 5.7 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 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?

Answer 1

WACC = rD (1- Tc )*( D / V )+ rE *( E / V )

Where...

rD = The required return of the firm's Debt financing
(1-Tc) = The Tax adjustment for interest expense
(D/V) = (Debt/Total Value)
rE= the firm's cost of equity
(E/V) = (Equity/Total Value)

WACC = 0.129*1/(1+0.8) + 0.057*0.8/(1+0.8) = 0.097 = 9.70%

Project discount rate = WACC + Adjustment factor = 9.70% + 1% = 10.70%

Maximum initial cost = (Aftertax cash savings)/(Discount rate - growth rate)

= 1890000 / (0.1070 - 0.02) = $21724137.93