Question

Hankins, Inc., is considering a project that will result in initial aftertax cash savings of $5.2 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 .51, a cost of equity of 13.1 percent, and an aftertax cost of debt of 6.5 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 +3 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? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

	a. Project required return _____% b. Maximum to pay______

Answer 1

Given Information:

Initial After-tax Cash Savings = $5.2 million = $5,200,000

Growth in Savings for an indefinite period (per annum) = 3%

Debt-Equity Ratio = 0.51

Cost of Equity (K_e) = 13.1%

After-tax Cost of Debt (K_d) = 6.5%

Adjustment Factor added to the cost of capital for this project = +3%

(a.) Projected Rate of Return:

Cost of Capital = Cost of Debt x Share of Debt + Cost of Equity x Share of Equity

   = 0.065x0.51 + 0.132x0.38

   = 0.03315+0.06419

   =0.09734 or 9.734%

Cost of Capital (with adjustment factor) = 9.73% + 3% = 12.73%

It is important to note that cost of capital is the minimum rate of return which is required by the company to cover up the costs of raising debt and equity. Hence, it is important for the business to have a higher rate of return so as to make profit on the project being undertaken by the company's management.

Thus, the projected rate of return, in this case, is equal to the adjusted cost of capital, that is, 12.73%.

(b.) Maximum to pay:

The maximum cost the company is willing to pay for this project is directly dependent on the positivity of NPV or Net Present Value of the project. NPV can be defined as the difference between the present value of cash inflows and cash outflows. It is important to note that the cash flows grow by 3% per annum on an indefinite basis or perpetually. Thus, the present value of future cash flows is calculated in the following manner:

After-tax Cash Flows per year = $5,200,000 x 0.03 = $156,000

PV of future cash flows = $156,000/ (0.1273-0.03) = $156,000/0.0973 = $16,03,288.7975

Thus, the maximum cost to pay = $16,03,288.80

If it is more than this cost, the project should be rejected as it will result in negative NPV for the company.