Question

Based on market values, Gubler's Gym has an equity multiplier of 1.69 times. Shareholders require a return of 11.83 percent on the company's stock and a pretax return of 5.07 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 $323,000 per year for 7 years. The tax rate is 35 percent. What is the most the company would be willing to spend today on the project? Multiple Choice $1,621,832 $1.852.645 $1,852,645 $1,575,494 oooo $1,661,968 $1,522,978

Answer 1

Equity Ratio = 1 / Equity Multiplier = 1 / 1.69 = 0.5917

WACC = [wD * kD * (1 - t)] + [wE * kE]

= [(1 - 0.5917) * 5.07% * (1 - 0.35)] + [0.5917 * 11.83%]

= 1.3455% + 7% = 8.3455%

PV of Annual After-tax cash flow = Annual After-tax cash flow * [{1 - (1 + r)^-n} / r]

= $323,000 * [{1 - (1 + 0.083455)^-7} / 0.083455]

= $323,000 * [0.4294 / 0.083455]

= $323,000 * 5.1454 = $1,661,968.23, or $1,661,968

So, 4th option is correct.