Question

Based on market values, Gubler's Gym has an equity multiplier of 1.52 times. Shareholders require a return of 11.15 percent on the company's stock and a pretax return of 4.90 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 $289,000 per year for 9 years. The tax rate is 39 percent. What is the most the company would be willing to spend today on the project?

Multiple Choice

• $1,731,793

• $1,778,775

• $1,626,236

• $2,050,380

• $1,682,313

Answer 1

Step 1 :	Calculation of WACC
	Equity multiplier = Total Assets / Equity
	1.52 =Total Assets / Equity
	Total Assest = 1.52 Equity
	Weight of equity = 1/1.52
	=65.79%
	Weight of Debt =100%-65.79%
	=34.21%
	After-tax cost of debt = cost of debt ×(1-tax rate)
	=0.049× (1-0.39)
	=0.049× 0.61
	=2.99 %
	WACC= (Cost of Debt * Weight Of Debt)+ (Cost of Equity * Weight of equity)
	=(0.0299*0.3421) + (0.1115*0.6579)
	=0.01022879+0.07335585
	=8.36%
Step 2:	Calculation of company willing to pay
	Present Value Of An Annuity
	= C*[1-(1+i)^-n]/i]
	Where,
	C= Cash Flow per period
	i = interest rate per period
	n=number of period
	= $289000[ 1-(1+0.0836)^-9 /0.0836]
	= $289000[ 1-(1.0836)^-9 /0.0836]
	= $289000[ (0.5145) ] /0.0836
	= $17,78,775   (rounded off)