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Och, Inc., is considering a project that will result in initial after-tax cash savings of $1.82 million at the end of the first year, and these savings will grow at a rate of 3 percent per year indefinitely. The company has a target debt-equity ratio of .85, a cost of equity of 12.2 percent, and an after-tax cost of debt of 5 percent. The cost-saving proposal is somewhat riskier than the usual projects 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.
Required:
(a) What is the maximum initial cost that the company would be willing to pay for the project?
(b) Under what condition the company cost of capital is the correct discount rate for new projects?
(c) What can go wrong if only using the company cost of capital as the hurdle rate to determine which new projects should be accepted or rejected? Then how to fix it?
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