Question

Sommer, Inc., is considering a project that will result in initial aftertax cash savings of $1.79 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 11.9 percent, and an aftertax cost of debt of 4.7 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 2 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?

Answer 1

Answer:

Maximum initial cost would be $58,116,883.12

Explanation:

1,790,000 increased at 3%

$WACC = K_e(\frac{E}{E+D}) + K_d(1-t)(\frac{D}{E+D})$

Ke 0.119 + 0.02 = 0.139

ER 0.15

Kd(after-tax) Kd(1-t) = 0.047

DR 0.85

$WACC = 0.139(0.15) + 0.047(.85)$

WACC 0.06080

Now that we have the rate, we calculate the present value using the gordon method

1,790,000 / (0.06080-0.03) = 58,116,883.12