Answer:
The maximum that the company should consider spending on this project is $12,820,512.82
Explanation:
The project's returns are in the form of a perpetuity of $1000000 or $1 million per year. A perpetuity is a constant cash flow that occurs after equal intervals of time indefinitely.
To calculate the maximum amount that the company should consider spending on this project, we need to determine the present value of perpetuity.
The formula for present value of perpetuity is,
Present value of perpetuity = Cash Flow / Discount rate
The discount rate in this case will be the WACC of the company. The WACC or weighted average cost of capital is the cost of the company's capital structure that can contain the following components namely debt, preferred stock and common stock.
To fund this project, the company will raise 60% amount from debt financing at 5% cost of debt and 40% from common stock financing at 12% cost of common stock equity.
The WACC will be,
WACC = wD * rD + wE * rE
Where,
- w is the weight of each component
- r is the cost of each component
- D is debt and E is common stock
WACC = 0.6 * 0.05 + 0.4 * 0.12 = 0.078 or 7.8%
The present value of perpetuity discounted at 7.8% will be,
Present value of perpetuity = 1000000 / 0.078
Present value of perpetuity = $12,820,512.82
