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Hankins, Inc
Hankins, Inc., is considering a project that will result in initial aftertax 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.
a.Calculate the discount rate for the project. (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 enter your answer in dollars, not millions, rounded to 2 decimal places, e.g., 1,234,567.89.)
Expert Solution
a. Computation of Discount Rate for the Project:
Discount Rate = Weight of Debt*After Tax Cost of Debt + Weight of Equity*Cost of Equity
= (0.40/(1+0.40))*3.2% + (1/(1+0.40))*10.8%
= 0.2857*3.2% + 0.7143*10.8%
= 0.009143 + 0.077143
Discount Rate = 0.0863 or 8.63%
b. Computation of Maximum Cost the company would be willing to pay for this project:
Adjusted cost of capital = 8.63%+2% = 10.63%
Maximum Cost = Year 1 Cash Flow/(Adjusted Cost of Capital - Growth Rate)
= $4,300,000/(10.63%-1.9%)
= $4,300,000 / 8.73%
Maximum Cost = $49,263,502.45
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