Photosynthesis, Inc. is considering a project that will result in initial after-
ID: 2662800 • Letter: P
Question
Photosynthesis, Inc. is considering a project that will result in initial after-tax cash savings of $4 million at the end of the first year and these savings will grow at a rate of 5% per year indefinitely. The firm has a target debt-equity ratio of .75, a cost of equity of 16%, and an after-tax cost of debt of 6%.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 +12% to the cost of capital for such risky projects.
Under what circumstances should Photosynthesis take on the project?
Explanation / Answer
I assume we should use the Gordon growth model for this which is: Po= D(1+g)/(k-g) Where D is the dividend (in this case the savings to the company), g is the growth rate of the dividend, and k the required rate of return. The company's weighted average cost of capital is: 1.12[ .75 *.06 +.25* .16)]= .0952 So we have 4 (1.05)/(.0952-.05)= 92.92. So the worth to the company would be 92.92 million and the company should consider investing up to this amount in resources to make it happen.