Ace Company Investment Analysis | Minimum After-Tax Cash Flow Calculation

Minimum After-Tax Cash Flow for Acceptable Investment by Ace Company

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Question

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 cost of capital 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?

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A. B. C. D. E.

E

$105,000 = CF(AT)/0.09; CF(AT) = $9,450.

To determine the minimum after-tax cash flow that would make the investment acceptable to Ace, we need to calculate the net present value (NPV) of the investment. The NPV is the present value of all future cash flows generated by the investment, discounted at the firm's cost of capital. If the NPV is positive, it means that the investment is expected to generate a return higher than the cost of capital and is therefore acceptable.

In this case, the property is expected to generate a constant cash flow forever. Let's denote this cash flow as CF. To calculate the CF, we need to determine the after-tax cash flow.

First, we need to calculate the after-tax cash flow. The cash flow before taxes (CFBT) can be calculated as follows:

CFBT = CF / (1 - tax rate) = CF / (1 - 0.4) (since the corporate tax rate is 40%) = CF / 0.6

Since the property will generate a constant cash flow forever, the after-tax cash flow (CFAT) will also be constant. Therefore, CFAT = CFBT.

Next, we need to calculate the present value (PV) of the cash flow. The present value is calculated using the following formula:

PV = CFAT / (1 + cost of capital)^n

Where n is the time period. Since the property is expected to generate cash flows forever, we can consider it as a perpetuity and use the perpetuity formula:

PV = CFAT / cost of capital

Given that the cost of capital is 9 percent, we can calculate the present value of the cash flow as follows:

PV = CFAT / 0.09

Now, we need to find the minimum CFAT that would make the investment acceptable, which means the NPV should be positive. The NPV is calculated by subtracting the initial investment cost from the present value of the cash flow:

NPV = PV - Initial investment cost

We know that the initial investment cost is $105,000. Let's substitute the formula for PV into the NPV equation:

NPV = CFAT / 0.09 - $105,000

For the investment to be acceptable, the NPV should be greater than or equal to zero. Solving for CFAT:

CFAT / 0.09 - $105,000 >= 0

CFAT / 0.09 >= $105,000

CFAT >= $105,000 * 0.09

CFAT >= $9,450

Therefore, the minimum after-tax cash flow that would make the investment acceptable to Ace is $9,450.

Hence, the correct answer is E. $9,450.

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