Question

Problem 14-20 WACC and NPV [LO3, 5]

Sommer, Inc., is considering a project that will result in initial aftertax cash savings of $1.88 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 .85, a cost of equity of 12.8 percent, and an aftertax cost of debt of 5.6 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.

What is the maximum initial cost the company would be willing to pay for the project? (Do not round intermediate calculations and enter your answer in dollars, not millions, rounded to the nearest whole dollar amount, e.g., 1,234,567.)

What is the maximum cost?

Answer 1

D/A = D/(E+D)

D/A = 0.85/(1+0.85)

=0.4595

Weight of equity = 1-D/A

Weight of equity = 1-0.4595

W(E)=0.5405

Weight of debt = D/A

Weight of debt = 0.4595

W(D)=0.4595

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5.6*(1-0)

= 5.6

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=5.6*0.4595+12.8*0.5405

WACC =9.49%

Discount rate for project =WACC+2% = 11.49%

Max to pay = savings year 1/(Discount rate-growth rate) = 1880000/(0.1149-0.03)=22143699