Hankins, Inc., is considering a project that will result in initial after tax cash savings of $4.3 million at the end of the first year, and these savings will grow at a rate of 1.9 percent per year indefinitely. The firm has a target debt-equity ratio of .40, a cost of equity of 10.8 percent, and an aftertax cost of debt of 3.2 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.

Required:
a. Calculate the discount rate for the project.
b. What is the maximum cost the company would be willing to pay for this project?

Question

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fichoh fichoh · Answer 1 · 2020-10-11T10:57:47+02:00

Answer:

9.76%

$54,707,379.13

Explanation:

Given the following :

Debt - Equity ratio = 0.4

Weight of debt(Wd) = 0.4

Weight of equity (We) = 1 - 0.4 = 0.6

Cost of Equity (Ke) =10.8%

Initial cashflow = $4.3 million

After tax cost of debt (Rd) = 3.2%

Adjustment factor (A) = +2%

Growth rate = 1.9%

Weighted average cost of capital:

(Weight of equity * cost of equity) + (after tax cost of debt * weight of debt)

(0.6 * 10.8%) + (3.2% * 0.4) = 0.0776

=0.0776 * 100% = 7.76%

Add the adjustment factor :

WACC + A = 7.76% + 2% = 9.76%

Hence, discount rate = 9.76%

Maximum amount to pay:

Using the relation:

Present value (PV) = Initial cashflow /(discount rate - growth rate)

PV = 4,300,000/ (9.76% - 1.9%)

PV = 4,300,000 / 7.86%

PV = 4,300,000 / 0.0786

PV = $54,707,379.13

PV = maximum company will be willing to pay