Question

Based on market values, Gubler's Gym has an equity multiplier of 1.55 times. Shareholders require a return of 11.27 percent on the company's stock and a pretax return of 4.93 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 $295,000 per year for 8 years. The tax rate is 39 percent. What is the most the company would be willing to spend today on the project? Multiple Choice $1,631,539 $1,901,399 $1,532,093 $1,584,924 $1,673,723

Answer 1

$1,673,723

Step-by-step explanation:

equity multiplier = total assets / total equity = 1.55

8 annual after tax cash flows of $295,000

we need to calculate the company's WACC = (1 / 1.55 x 11.27%) + [0.55 / 1.55 x 4.93% x (1 - 39%)] = 7.27% + 1.07% = 8.34%

We need to determine the present value of the cash flows using the WACC as our discount rate. Using a financial calculator or an excel spreadsheet, the PV of the cash flows = $1,673,602

the PV that I calculated is very similar to $1,673,723, there is a margin of error of 0.007% due to rounding in the WACC calculation.