Question

Based on market values, Gubler's Gym has an equity multiplier of 1.56 times. Shareholders require a return of 11.31 percent on the company's stock and a pretax return of 4.94 percent on the company's debt. The company is evaluating a new project that has the same risk as the company itself. The project will generate annual aftertax cash flows of $297,000 per year for 9 years. The tax rate is 40 percent. What is the most the company would be willing to spend today on the project?

Answer 1

Answer:

$1,831,342.6

Explanation:

Firstly, we need to calculate weighted average cost of capital (WACC) for Cannoli Corp:

WACC = Weight of equity x Cost of equity + Weight of debt x Pretax cost of debt x (1 - Tax rate)

           = (1/1.56) x 11.31% + (1 - 1/1.56) x 4.94% x (1 - 40%)

           = 8.314%

Next, we need to calculate present value (PV) of all cashflow of this project:

PV = CF1/(1 +  WACC) + CF2/(1 +  WACC)^2 + ... + CF9/(1 +  WACC)^9

     = 297,000/(1 +  8.314%) + 297,000/(1 +  8.314%)^2 + ... + 297,000/(1 +  8.314%)^9

     = 1,831,342.6

The maximum price that the company would be willing to spend for this project is its PV of $1,831,342.6