Question

5) Scanlin, Inc. is considering a project that will result in initial aftertax cash savings of $2.1 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 percent and an aftertax cost of debt of 4.6 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. Under what circumstances should the company take on the project

Answer 1

Answer:

The PV of future cash flow is $22,925,764, therefore the company should take on the project

Explanation:

In order to know if the company should take on the project we have to calculate the PV of future cash flow as follows:

PV of future cash flow=    D1    

                                        RE-g

To calculate this formula we requre to calculate the WACC and the discount rate as follows:

WACC=(1.00/1.80×0.11)+0+(0.80/1.80×0.046)

WACC=0.0611+0+0.02044

WACC=0.081556

WACC=8.16%

After having calculated the WACC we can calculate the project discount rate as follows:

project discount rate=WACC + Additional risk factor

=8.16%+3%

=11.16%

Therefore, PV of future cash flow= $2,100,000

                                                            0.1116-0.02

PV of future cash flow= $2,100,000

                                            0.0916

PV of future cash flow=$22,925,764

The PV of future cash flow is $22,925,764, therefore the company should take on the project