Problem 13-16 WACC and NPV Och, Inc., is considering a project that will result
ID: 2753322 • Letter: P
Question
Problem 13-16 WACC and NPV
Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.76 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 11.6 percent, and an aftertax cost of debt of 4.4 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 +1 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.)
Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.76 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 11.6 percent, and an aftertax cost of debt of 4.4 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 +1 per cent to the cost of capital for such risky projects.
Explanation / Answer
Maximum initial cost:
= $1.76 million÷(9.29%-3%)
= $53,464,565
WACC = Wd×Rd×(1-t)+We×Ke W is weights of respective portfolios R is return on respective portfolios Cost of equity 11.60% After tax cost of debt 4.40% Equity weight 0.54 Debt weight 0.46 WACC 8.29% Add: Adjustment factor 1% Relevant discount rate for project 9.29%