fin 305 ch 11 q 16 A firm is considering a project that will generate perpetual

Question

fin 305 ch 11 q 16

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 and round your answer to the nearest whole dollar.)

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

Explanation / Answer

D/E = .7/1

D/A = 0.7/(0.7+1) = 0.4117

E/A = 1-D/A = .58823

WACC = Cost of equity*E/A + cost of debt*E/A = 15*0.58823 + 6*.4117 = 11.294%

0 = Max initial investment - perpetual cashflow/WACC

Max initial investment = 18000/.11294 = 159376

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