Question

Sommer, Inc., is considering a project that will result in initial aftertax cash savings of $1.84 million at the end of the first year, and these savings will grow at a rate of 1 percent per year indefinitely. The firm has a target debt-equity ratio of .75, a cost of equity of 12.4 percent, and an aftertax cost of debt of 5.2 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 3 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:

$19,700,214.13

Explanation:

According to the scenario, computation of the given data are as follow:-

WACC = (Debt Equity Ratio ÷ 1 + Debt Equity Ratio) × After Tax Cost of Debt + (1 ÷ Debt Equity Ratio) × Cost of Equity

=(.75 ÷ 1+.75) × 0.052+(1 ÷ 1.75) × 0.124

= (.75 ÷ 1.75) × 0.052 + 0.57 × 0.124

= 0.43 × 0.052 + 0.071

= 0.0934 = 9.34%

Project Discount Rate = WACC + Adjustment Factor Rate

= 9.34% + 3% = 12.34%

If NPV is positive, we would accept the project:-

PV of Future Cash Flow = Initial After Tax Cash Savings ÷ (Project Discount Rate - Adjustment Factor Rate)

= $1,840,000 ÷ (0.1234-0.03)

= $1,840,000 ÷ 0.0934

= $19,700,214.13

According to the analysis, the project should only taken when the NPA is less than $19,700,214.13.