Question

Hankins, Inc., is considering a project that will result in initial aftertax cash savings of $6.3 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 .62, a cost of equity of 13.2 percent, and an aftertax cost of debt of 5.7 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. a.Calculate the required return for the project. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)b.What is the maximum cost the company would be willing to pay for this project

Answer 1

Answer:

A. 12.3%

B. 68%

Explanation:

a.Calculation to determine the required return for the project

Required return=(0.62/1.62*5.7%)+(1/1.62*13.2%)+2%

Required return=0.022+0.081+2%

Required return=0.124*100

Required return=12.3%

Therefore the required return for the project will be 12.3%

b. Calculation to determine the maximum cost the company would be willing to pay for this project

Maximum cost =6.3/(12.3%-3%)

Maximum cost =6.3/9.3%

Maximum cost =0.67.7*100

Maximum cost =67.7%

Maximum cost=68% (Approximately)

Therefore the maximum cost the company would be willing to pay for this project will be 68%