The Ace Company is considering investing in a piece of property which costs $105,000.The property will return a constant cash flow forever.If the firm's required rate of return is 9 percent and the corporate tax rate is 40 percent,what is the minimum after-tax cash flow that would make the investment acceptable to Ace?
A) $15,942
B) $10,831
C) $9,450
D) $2,375
E) $5,000

Question

Quizplus · Accepted Answer

The minimum after-tax cash flow can be calculated as follows:
1. Calculate the pre-tax cash flow: 
PV of perpetuity = CF / r 
105,000 = CF / 0.09 
CF = $9,450

2. Calculate the after-tax cash flow: 
Taxable income = pre-tax cash flow - depreciation 
Assuming the property has no salvage value and depreciates over 27.5 years using straight-line depreciation: 
Depreciation = 105,000 / 27.5 = $3,818.18 per year 
Taxable income = 9,450 - 3,818.18 = $5,631.82

Taxes = 0.4 * taxable income = 0.4 * 5,631.82 = $2,252.73 
After-tax cash flow = pre-tax cash flow - taxes + depreciation 
After-tax cash flow = 9,450 - 2,252.73 + 3,818.18 = $10,015.45

Therefore, the minimum after-tax cash flow that would make the investment acceptable to Ace is $9,450, which is the pre-tax cash flow. Choice C is the closest option to this amount.

The Ace Company Is Considering Investing in a Piece of Property