Problem 13-16 WACC and NPV Och, Inc., is considering a project that will result
ID: 2729264 • Letter: P
Question
Problem 13-16 WACC and NPV Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.70 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 11.0 percent, and an aftertax cost of debt of 3.8 percent. 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 +2 per cent to the cost of capital for such risky projects. What is the maximum initial cost of company would be willing to pay for the project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)
Maximum cost $
Explanation / Answer
Answer: WACC = (.85/1.85)(.038) + (1/1.85)(.11)
= .0769, or 7.69%
Since the project is riskier than the company, we need to adjust the project discount rate for the additional risk. Using the subjective risk factor given, we find:
Project discount rate = 7.69% + 2.00% = 9.69%
We would accept the project if the NPV is positive. The NPV is the PV of thecash outflows plus the PV of the cash inflows. Since we have the costs, we justneed to find the PV of inflows. The cash inflows are a growing perpetuity. If youremember, the equation for the PV of a growing perpetuity is the same as the dividend growth equation, so:
PV of future CF = $1,700,000/(9.69% – 3%) = $25411061.29
The project should only be undertaken if its cost is less than $25411061.29 since costs less than this amount will result in a positive NPV.