Question

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.
Required:
(a) Calculate the WACC. (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.)

Answer 1

Answer:

a) the WACC is 11.47%

b) The maximum cost the company would be willing to pay for this project is $76,741,440.38

Explanation:

D/A = D/(E+D)

D/A = 0.64/(1+0.64)

=0.3902

Weight of equity = 1-D/A

Weight of equity = 1-0.3902

W(E)=0.6098

Weight of debt = D/A

Weight of debt = 0.3902

W(D)=0.3902

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5.9*(1-0)

= 5.9

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=5.9*0.3902+13.4*0.6098

WACC =10.47%

WACC for project = WACC+adj.

                             = 10.47+1

                              =11.47%

b) maximum cost= CF in 1 year/(WACC - growth rate)

                            = 6500000/ (0.1147 - 0.03)

                           = $76741440.38