Question

Assume that a company is 35% debt and 65% equity financed. The company has a 10% cost of equity and 8% after-tax cost of debt. It considers undertaking a project which has a life of 5 years. If the cash flows of the project are, on the average, spread evenly over the life of the project, the optimal cutoff period is closest to:

Select one:
a. 3.9 years
b. 4.2 years
c. 5.1 years
d. 6.1 years

Answer 1

Answer is Option (a) (i.e., 3.9 years)

Computation of Weighted Average Cost of Capital:

Cost of equity (R(e)) = 10%

Cost of debt after tax (R(d)) = 8%

Equity portion (W(e)) = 65%

Debt portion (W(d)) = 35%

WACC = W(e)*R(e) + W(d)*R(d)

= 10%*65% + 8%*35%

= 6.5% + 2.8%

= 9.3%

Period of project = 5 years

The cutoff period is the annuity factor @ WACC for 5 years when project cash flows are equal.

Annuity factor is;

= (1-(1/(1+r)^n))/r
= ((1-(1/(1+0.093)^5))/0.093)
= 3.85 years

Therefore, the cutoff period is 3.9 years (approx.)