Question

Sallinger, Inc. is considering a project that will result in initial after-tax cash savings of $6 million at the end of the first year, and these savings will grow at a rate of 1 percent per year indefinitely. The firm has a target debt-equity ratio of 0.75, a cost of equity of 16 percent, and an after-tax cost of debt of 7 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. Under what circumstances should Sallinger take on the project?

Answer 1

Answer : Circumstances in which the project should be undertaken by Sallinger :-->

Given the Debt - Equity ratio = 0.75 :1

Therefore

Weight of Equity = 1 / (1+0.75)

     = 1 / 1.75

   = 0.57143

Weight of Debt = 1 - 0.57143

= 0.42857

WACC = (Cost of Equity * Weight of Equity) + (After tax Cost of Debt * Weight of Debt)

= (16% * 0.57143) + (7 % * 0.42857)

= 9.14288 + 2.99999

= 12.14287 % or 12.143 %

Cost of Project = 12.143% + 2

= 14.143 % or 0.14143

Present value of Future cash flows = After tax cash savings / (Cost of Project - Growth rate )

= 6 million / ( 0.14143 - 0.01)

= $ 6 million / 0.13143

= $ 45.652 million

NPV = -cost + PV of future cashflows

0 = - cost + 45.652

cost = $ 45.652

Therefore The project should be undertaken if the cost is less than $45.652 million.