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.
a) Calculate the WACC.
b) What is the maximum cost the company would be willing to pay for this project?
Weighted Average Cost of Capital:
Firms often need to raise capital externally to finance new projects and investments, and the cost they face is the weighted average cost of capital. External funds are usually raised through issuance of new debts and equities, and the weighted average cost of capital is the market value weighted average of after-tax cost of debt and the cost of equities.
Answer and Explanation:
a. WACC is 10.475%.
To find WACC, we first need to identify the firm's capital structure. With a debt-equity ratio of 0.64, the weight on debt = 0.64 / (1 + 0.64) = 0.39, and the weight on equity = 1 - 0.39 = 0.61.
WACC is the weighted average of after-tax cost of debt and the cost of equity, i.e., 0.39*5.9% + 0.61*13.4% = 10.475%.
b. The maximum cost is $79.70 million.
The maximum cost the company is willing to pay is the present value of the savings generated from the project, discounted at the appropriate discount rate. In this case, the net present value of the project is exactly zero. If the company pays more than that, the the project leads to a loss and should not be accepted.
The appropriate discount rate = WACC + 1% = 10.475% + 1% = 11.475%.
Since the savings grow at a constant rate of 3% indefinitely, the present value = 6.5 / (11.475% - 3%) = $79.70 million.
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from Finance 101: Principles of FinanceChapter 14 / Lesson 5
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