Question

Carson Electronics uses 58 percent common stock and 42 percent debt to finance its operations. The aftertax cost of debt is 5.4 percent and the cost of equity is 15.3 percent. Management is considering a project that will produce a cash inflow of $49,600 in the first year. The cash inflows will then grow at 2.5 percent per year forever. What is the maximum amount the firm can initially invest in this project to avoid a negative net present value for the project?

Answer 1

Answer:

$573,941.22

Explanation:

Use WACC formula to find the cost of capital for discounting the given cashflows;

WACC = wE*rE + wD*rd (1-tax)

whereby;

wE = weight of equity

rE = cost of equity

wD = weight of debt

rd (1-tax) = aftertax cost of debt

WACC = (0.58*0.153) + (0.42 *0.054)

= 0.08874 + 0.02268

= 0.1114 or 11.14%

Find the present value of the growing perpetual cashflows which will be equivalent to the maximum initial outlay of the project needed to avoid a negative NPV;

PV = CF/ (WACC - g)

Cashflow; CF = $49,600

WACC = 11.14%

growth rate ; g = 2.5%

PV = 49,600/ (0.1114 - 0.025)

PV = 573,941.22

Therefore, maximum amount the firm can initially invest in this project to avoid a negative net present value is $573,941.22