Question

Sommer, Inc., is considering a project that will result in initial aftertax cash savings of $1.75 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 11.5 percent, and an aftertax cost of debt of 4.3 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.

Answer 1

Answer:

The question is: "What is the maximum initial cost the company would be willing to pay for the project?"

The maximum initial investment cost the company would be willing to pay for the project is $18,817,204.

Explanation:

We have D/E = 0.8 => D/ (D+E) = 4/9; E/(D+E) = 5/9.

WACC of the firm = 4/9 x 4.3% + 5/9 x 11.5% = 8.3%.

Adjustment for cost capital due to higher risk of the project: 8.3% + 3% = 11.3%.

=> Maximum initial investment cost is equal to the net present value of the cash saving the project brings about discounting at project's cost of capital, calculated as:

1,750,000/ (11.3% - 2%) = $18,817,204.

Thus, the Maximum initial investment cost is $18,817,204.