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

Sol:

Debt weight = 35% = 0.35

Equity weight = 65% = 0.65

Cost of debt = 8%

Cost of equity = 10%

Project life (n) = 5 years

Rate (r) = (Debt weight x Cost of debt) + (Equity weight x Cost of equity)

Rate (r) = (0.35 x 8%) + (0.65 x 10%)

Rate (r) = 2.8% + 6.5% = 9.3%

To compute optimal cutoff period:

Optimal cutoff period = (1/r) - (1/(r x (1+r)^n)

Optimal cutoff period = (1/9.3%) - (1/(9.3% x (1+9.3%)^5)

Optimal cutoff period = (1/0.093) - (1/(0.093 x (1+0.093)^5)

Optimal cutoff period = 10.752688 - 6.893126

Optimal cutoff period = 3.859567 or 3.9 years

Therefore optimal cutoff period will be 3.9 years.

Answer is a. 3.9 years