Question

A firm is considering a project that will generate net cash flows of $50,000 per year for ten years beginning immediately. The project has the same risk as the firm's overall operations. If the firm's debt-to-equity ratio is 0.75, its required return on equity is 8% and its required return on debt is 6%, what is the most it could pay for the project? (Assume the firm pays no taxes)

Select one:

a. $435,504

b. $373,830

c. $235,960

d. $212,868

e. $348,880

Answer 1

Debt to equity	0.75
Equity = Total assets - Total debt
Debt / equity = 0.75
Total Debt / ( Total assets - Total debt ) = 0.75
Total debt = 0.75 * ( Total assets - Total debt )
Total debt = 0.75Total assets - 0.75total debt
0.75Total assets = 1.75 Total debt
Total debt / Total assets = 0.75 / 1.75
Total equity / Total assets = 1 - 0.75/1.75 = 1 / 1.75
Weighted average cost of capital (WACC) = 8%*(1/1.75) + 6%*(0.75/1.75)	7.143%
Maximum amount to be paid = Annual cash flow * PVAF,7.14%,10years = 50000 * ( 1-(1+r)^-n)/r ) = 50000*(1-(1+7.14%)^-10)/7.14%)	348880