Problem 13-16 WACC and NPV Och, Inc., is considering a project that will result
ID: 2753401 • 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?
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
Weighted average cost of capital = cost of debt * debt / (debt +equity) + cost of equity * equity/(debt +equity)
=0.044 * 85/185 + 0.116 * 100/185
= 0.020 + 0.063
= 8.3%
New adjusted WACC = 8.3% + 1%(adjustment factor) = 9.3%
maximum initial cost of capital = after tax saving at 1year end ( 1 + growth) / adjusted WACC - growth)
= 1760000(1+0.03) / 9.3%-3%
= 1812800 / 6.3%
= $28774603.17
Note:- debt -equity = debt / equity = 0.85
= 85/100
thersfore, debt + equity = 85 + 100 = 185