A firm is considering a project that will generate perpetual after-tax cash flow

Question

A firm is considering a project that will generate perpetual after-tax cash flows of $21,500 per year beginning next year. The project has the same risk as the firm’s overall operations and must be financed externally. Equity flotation costs 11 percent and debt issues cost 5 percent on an after-tax basis. The firm’s D/E ratio is 0.6.

What is the most the firm can pay for the project and still earn its required return?

A firm is considering a project that will generate perpetual after-tax cash flows of $21,500 per year beginning next year. The project has the same risk as the firm’s overall operations and must be financed externally. Equity flotation costs 11 percent and debt issues cost 5 percent on an after-tax basis. The firm’s D/E ratio is 0.6.

Explanation / Answer

cost of capital = (0.6*5% + 1*11%)/1.6 = 8.75%

most that the firm can pay = 21,500/0.0875 = 245,714.29

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