Question

Based on market values, Gubler's Gym has an equity multiplier of 1.51 times. Shareholders require a return of 11.11 percent on the company's stock and a pretax return of 4.89 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 $287,000 per year for 8 years. The tax rate is 35 percent. What is the most the company would be willing to spend today on the project?

Answer 1

Equity multiplier = 1.51
Equity Ratio = 1/1.51 = 66.22%

Debt Ratio = 100% -66.22% = 33.78%

Calculation of cost of capital

Particulars	Weight	Cost	Weight x Cost
Equity	66.23%	11.11%	7.36%
Debt	33.77%	3.18% {4.89% - (1-.35)}	1.07%
			8.43%

Amount willing to spent

Year	cashflow	PV @ 8.43%	Present Value
1	$       2,87,000	0.92225	$                   2,64,686.89
2	$       2,87,000	0.85055	$                   2,44,108.54
3	$       2,87,000	0.78443	$                   2,25,130.08
4	$       2,87,000	0.72344	$                   2,07,627.11
5	$       2,87,000	0.66719	$                   1,91,484.93
6	$       2,87,000	0.61532	$                   1,76,597.74
7	$       2,87,000	0.56748	$                   1,62,867.97
8	$       2,87,000	0.52336	$                   1,50,205.64
Total	$                16,22,708.92

The company would be willing to spend today $1622708.92

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