Question

Hankins, Inc., is considering a project that will result in initial aftertax cash savings of $4.3 million at the end of the first year, and these savings will grow at a rate of 1.9 percent per year indefinitely. The firm has a target debt-equity ratio of .40, a cost of equity of 10.8 percent, and an aftertax cost of debt of 3.2 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 the company take on the project?

Answer 1

Target Debt to Equity = 0.4, Equity Proportion = 1/1.4 and Debt Proportion = 0.4/1.4, Cost of Equity = 10.8 % and After-Tax Cost of Debt = 3.2 %

Weighted Average Cost of Capital (WACC) = (0.4/1.4) x 3.2 + (1/1.4) x 10.8 = 8.62857 %

Adjusted Cost of Capital = 2 + 8.62857 = 10.62857 %

After-Tax Cash Savings = $ 4.3 million and Perpetual Growth Rate = 1.9%

Therefore, Present Value of Cash Savings = 4.3 / (0.1062857 - 0.019) = $ 4.92635 million

The company should take up the project only when the project cost is lower than the present value of the project's cash savings so that the project has a positive NPV.