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 $18,000 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 15 percent and debt issues cost 6 percent on an after-tax basis. The firm’s D/E ratio is 0.7.

What is the most the firm can pay for the project and still earn its required return? (Do not round intermediate calculations. Round your final answer to the nearest whole dollar.)

A firm is considering a project that will generate perpetual after-tax cash flows of $18,000 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 15 percent and debt issues cost 6 percent on an after-tax basis. The firm’s D/E ratio is 0.7.

Explanation / Answer

First, we need to calculate the weighted cost of capital (WACC).

Debt-Equity Ratio = Debt / Equity = 0.7 / 1

From above, we can conclude that if Debt is 0.7, then Equity is 1.

Total Weight = 0.7 + 1 = 1.7

Weight of debt = 0.7 / 1.7, Weight of equity = 1 / 1.7

WACC = Cost of Equity x Weight of Equity + After Tax Cost of Debt x Weight of debt = (15% x 1 / 1.7) + (6% x 0.7/ 1.7) = 11.294117647%

Maximum amount the firm would pay would be the value of the Present value of after tax cash flows. Since, these are perpetual cash flows, maximum amount would be computed as -

Maximum amount = After tax cash flows / WACC = $18000 / 0.11294117647 = $159375

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