Bono, Inc., is considering a project that will result in initial aftertax cash s

Question

Bono, Inc., is considering a project that will result in initial aftertax cash savings of $5.1 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 .50, a cost of equity of 13 percent, and an aftertax cost of debt of 6.4 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.

1. Calculate the WACC.
2. What is the maximum cost Bono would be willing to pay for this project?

Explanation / Answer

1. WACC= 0.5/1.5*6.4% + 1/1.5*13% =10.80% 2. Adjusted WACC =10.80%+2% = 12.80% maximum cost =$5.1/(12.80%-3%) = $52.04 million

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