Question

Problem 12-21 WACC and NPV [LO 4]

Hankins, Inc., is considering a project that will result in initial aftertax cash savings of $6.5 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 .64, a cost of equity of 13.4 percent, and an aftertax cost of debt of 5.9 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 +1 percent to the cost of capital for such risky projects.

Calculate the WACC. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
  
WACC             %

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.)
  
Present value            $

Answer 1

Solution:-

a) Calculation of WACC

WACC = K_d*(1-tax)* W_d+K_e*W_e

Where,

K_d*(1-tax) = After tax cost of debt = 5.9%

K_e= Cost of equity = 13.4%

Since the debt equity ratio =0.64

i.e Debt/Equity=0.64/1

Hence

W_d= Weight of debt = 0.64/1.64

W_e =Weight of equity= 1/1.64

Substituting the values we get

WACC= 5.9*0.64/1.64+13.4*1/1.64

WACC = 10.4731707%

Hence the WACC= 10.47%

The project discount rate= WACC + Adjustment

                                                               =10.4731707%+1%= 11.4731707%

Hence the project discount rate = 11.4731707%

b) calculation of maximum cost the company would be willing to pay for this project

In order to calculate PV of cash flow we can use formula for growing perpetuity

       PV of cash inflow = Cash flow/(RR-g)

Where Cash flow= $6.5 million

RR= Project discount rate = 11.4731707%

g= growth rate = 3%

Substituting the values we get,

Present value of cash inflow= $6,500,000 /(0.114731707-0.03)

                                  =$6,500,000 /0.0847317

                                  =$76,712,723.09

Hence the maximum cost the company will be willing to pay for this project =$76,712,723.09

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