Scanlin Inc is considering a project that will result in ini

Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $1.82 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 12.2 percent, and an aftertax cost of debt of 5 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? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.) Maximum cost

Solution

D/E = 0.85

Debt/Capital = 0.85/1.85

Equity/Capital = 1/1.85

WACC = (Wd x After Tax Kd) + (We x Ke)

= [(0.85/1.85) x 0.05] x [(1/1.85) x 0.122]

= 0.02297 + 0.06595 = 0.08892 or 8.892%

Adjusting the risk for the project:

Project Discount Rate = 0.08892 + 0.02 = 0.10892 or 10.892%

The company should only accept the project if the NPV is zero (hopefully greater than zero). The CFs are a growing annuity. The PV of a growing annuity can be found with the dividend discount equation.

PV = $1,820,000/(0.10892 - 0.03)

= $1,820,000/0.07892 = $23,061,643.84

Hence, the maximum initial cost = $23,061,643.84