Answer:
a.
WACC - Company = 10.94%
WACC - Project = 11.94%
b.
The maximum that the company will be willing to pay for this project is $61.0626 million
Explanation:
a.
To calculate the maximum cost that the company will be willing to pay today, we first need to find out the company and project WACC.
The WACC or weighted average cost of capital is the cost of a company's capital structure. It is calculated as follows,
WACC = wD * rD * (1 - tax rate) + wP * rP + wE * rE
Where,
- d, p and e represents debt, preferred stock and common equity
- w represents the weight of each component
- r represents the cost of each component
<u>Weightage of debt and equity</u>
Total assets = debt + equity
Total assets = 0.52 + 1 = 1.52
wD = 0.52/1.52
wE = 1/1.52
WACC - Company = 0.52/1.52 * 0.066 + 1/1.52 * 0.132
WACC - Company = 0.1094 or 10.94%
WACC of project is 1% more than WACC of company. So WACC of project is 10.94% + 1% = 11.94%
b.
The maximum that must be paid for this project can be calculated by calculating the present value of the cash flows provided in form of saving by this project.
Using the constant growth model of cash flow approach,
Present value = 5.3 * (1+0.03) / (0.1194 - 0.03)
Present value = $61.0626 million
