Question

3) A company XYZ is considering a project which would result in an initial cash savings of $3.5 million at the end of the first year, and the savings will grow at the rate of 4 % per year, forever. The company has a target debt equity ratio of 0.55, the cost of equity is 13%, and the cost of debt is 5.5%.

The cost saving proposal is riskier than the usual projects, so the firm uses an adjustment factor of +2% to the cost of capital for such risky projects.

Under what circumstances should the firm take the project? (What is the maximum initial investment that makes this profitable)

Answer 1

Formulas:

In millions
	0	1
Initial cashflow		3.5
Terminal Value		=C3*(1+B11)/(B20-B11)
Net Cash flow		=C3+C4
Present value of net cash flow	=C5/(1+B20)
Hence the maximum initial investment	=B7	Million
Given
Growth to perpetuity	0.04
D/E	0.55
Cost of Equity	0.13
Cost of Debt (After Tax)	0.055
Additional risk factor	0.02
D/V	=1/(1+1/B12)
E/V	=1-B17
WACC	=B18*B13+B17*B14
WACC + Additional risk	=B19+B15