Question

Hankins, Inc., is considering a project that will result in initial aftertax cash savings of $5.3 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 .52, a cost of equity of 13.2 percent, and an aftertax cost of debt of 6.6 percent. The cost-saving proposal is somewhat riskier than the usual project 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.Required:a. Calculate the WACC.b. What is the maximum cost the company would be willing to pay for this project?

Answer 1

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

Weightage of  debt and equity

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