Question

Based on market values, Gubler's Gym has an equity multiplier of 1.59 times. Shareholders require a return of 11.43 percent on the company's stock and a pretax return of 4.97 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 $303,000 per year for 8 years. The tax rate is 40 percent. What is the most the company would be willing to spend today on the project?

Answer 1

The amount is computed as shown below:

= 1 - 1 / Equity multiplier x pretax return x (1 - tax rate) + 1 / equity multiplier x required rate of return

= (1 - 1 / 1.59) x 0.0497 x (1 - 0.40) + 1 / 1.59 x 0.1143

= 0.082952075

So, the amount will be as follows:

Present value = Annual cash flows x [ (1 – 1 / (1 + r)ⁿ) / r ]

= $ 303,000 x [ (1 - 1 / (1 + 0.082952075)⁸ ) / 0.082952075 ]

= $ 303,000 x 5.682814965

= $ 1,721,892.934

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