Question

Based on market values, Gubler's Gym has an equity multiplier of 1.62 times. Shareholders require a return of 11.55 percent on the company's stock and a pretax return of 5.00 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 $309,000 per year for 7 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 maximum 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 / 1.62) x 0.05 x (1 - 0.40) + 1 / 1.62 x 0.1155

= 0.082777778

So, the amount will be as follows:

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

= $ 309,000 x [ (1 - 1 / (1 + 0.082777778)⁷ ) / 0.082777778]

= $ 309,000 x 5.157272803

= $ 1,593,597.296

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