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A firm is considering a project that will generate perpetual after-tax cash flows of $20,500 per year beginning next year
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A firm is considering a project that will generate perpetual after-tax cash flows of $20,500 per year beginning next year. The project has the same risk as the firm’s overall operations and must be financed externally. Equity flotation costs 16 percent and debt issues cost 3 percent on an after-tax basis. The firm’s D/E ratio is 0.5. |
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What is the most the firm can pay for the project and still earn its required return? |
Expert Solution
WACC is computed as:
= D/E ratio / (1 + D/E ratio) x cost of debt + 1 / (1 + D/E ratio) x cost of equity
= 0.5 / 1.5 x 0.03 + 1 / 1.5 x 0.16
= 0.01 + 0.1066666667
= 0.116666667
Therefore, the amount will be as follows:
= After tax cash flow / WACC
= $ 20,500 / 0.116666667
= $ 175,714.2857
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