Problem 13-16 WACC and NPV Och, Inc., is considering a project that will result

Question

Problem 13-16 WACC and NPV Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.72 million at the end of the first year, and these savings will grow at a rate of 2 percent per year indefinitely. The company has a target debt-equity ratio of.8, a cost of equity of 11.2 percent, and an aftertax cost of debt of 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 percent to the cost of capital for such risky projects. What is the maximum initial cost the company would be willing to pay for the project? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Maximum cost

Explanation / Answer

Debt equity ratio = 0.8

Therefore portion of debt in capital = 0.8/(1+0.8) = 0.44

Portion of Equity = 1 - portion of debt = 1-0.44 = 0.56

Cost of capital = re*we + rd*wd

where re and rd is cost of equity and debt respectively, we and wd is weight of equity and debt respectively

re = 11.2%

rd = 4%

So, cost of capital = (11.2*0.56) + (4*0.44) = 8%

After considering adjustment factor of 1 cost of capital = 8 + 1 = 9%

Cash saving after 1 year = $1.72 million

Cash saving is growing by 2% annually

Present value of cash saving = Current value *(1+g)/(r-g) ( as per Gordan growth model)

= 1720000*(1+0.02)/(0.09-0.02) = $25,062,857.14

Company would be willing to pay maximum initial value of the present valuye of cash saving, if company pays more than that it would go into loss

So compnay woul be willing to pay present value of cash saving i.e. $25,062,857.14

Therefore maximum cost = $25,062,857.14

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