Question

1. Scanlin, Inc., is considering a project that will result in initial aftertax cash savings of $2.1 million at the end of the first year, and these savings will grow at a rate of 2 percent per year indefinitely. The firm has a target debt–equity ratio of .80, a cost of equity of 11 percent, and an aftertax cost of debt of 4.6 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. Under what circumstances should the company take on the project?

Answer 1

Solution) Debt-equity ratio = 0.80

D/E = 0.8

D = 0.8*E

Weight of debt (Wd) = D/(D + E) = 0.8E/(0.8E + E)

= 0.8/1.8 = 0.44444

Weight of equity (We) = E/(D+E) = E/(0.8E + E) = E/1.8E = 1/1.8 = 0.55556

The weighted average cost of capital (WACC) = Wd*Kd*(1- tax%) + We*Ke

Where Wd = Weight od debt

Kd*(1-tax%) = After-tax cost of debt = 4.6%

We = Weight of equity

Ke = Cost of equity = 11%

WACC = 0.44444*4.6% + 0.55556*11%

= 0.020444 + 0.061111

= 0.0815555

= 8.16%

Since management has applied an adjustment factor of +3%, so, weighted average cost of capital (WACC) = 8.16% + 3% = 11.16%

The company would receive initial after-tax cash savings of $2.1 million at the end of the first year, and these savings will grow at a rate of 2 percent per year indefinitely.

The present value of the savings can be calculated using the Gordon Growth Model

= D1/(WACC - g)

D1 = Expected cash flow in year 1 = 2.1 million

WACC = 11.16%

g = growth rate = 2%

Thus, the present value of the savings = 2.1/(11.16% - 2%)

= 2.1/9.16%

= 22.925764

= 22.93 million or 22,925,764

The company should accept this project only when the present value of costs is less than the present value of after-tax savings, i.e.,

The present value of the costs < 22,925,764

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