Reference no: EM132764664

Consider a firm which is evaluating a project to produce solar water heaters. The project requires a $10 million investment and generates after-tax free cash flows of $1.75 million per year for 10 years. The opportunity cost of capital which reflects the project's business risk equals 12%. With this information answer the following two questions.

(i) Suppose the project is financed with $5 million debt and $5 million equity. The debt is provided as a term loan, which will be repaid in equal installments over the next 10 years. The interest rate on the debt equals 8% and the marginal corporate tax rate is 35%. Should the firm undertake the investment project? Motivate your answer and show all your calculations.

(ii) Suppose you learn that the firm incurs issue costs (in the form of underwriting fees) of $400,000 to raise the $5 million in equity for the project. How would this information affect your project recommendation? Explain your answer.