How much cash flow before tax and interest is necessary to support a project that requires $4 million annually for equity investors and $2 million annually in interest payments if the firm's tax rate is 35%?

Question

Quizplus · Accepted Answer

To support the project, the cash flow before tax and interest must cover the equity investors' required returns of $4 million and interest payments of $2 million. Therefore, the total cash flow required is:

$4 million (equity investors) + $2 million (interest payments) = $6 million

However, this is the amount before tax. To calculate the amount necessary before tax and interest, we need to account for the firm's tax rate of 35%. This means that to generate $6 million in cash flow before tax, the firm needs to generate:

$6 million / (1 - 0.35) = $9.23 million in pre-tax cash flow

Finally, to determine the amount necessary before tax and interest, we subtract the interest payments of $2 million, which gives us:

$9.23 million - $2 million = $7.23 million

Therefore, to support the project, the firm needs to generate $7.23 million in cash flow before tax and interest. Adding back the interest payments of $2 million gives us a total cash flow requirement of $9.23 million before tax. After accounting for the tax rate, the amount necessary before tax and interest is $8.15 million.

Therefore, the best choice is C) $8.15 million.

How Much Cash Flow Before Tax and Interest Is Necessary