Finance problem - Please Help?

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 maximum after-tax cash flow that would make the investment acceptable to Ace?

Do your own homework.

There is no maximum - the higher the cash flow the better. For example, $100 million would be better than $90 million. So I think you really are asking about the minimum cash flow, rather than the maximum cash flow.

If the firm's required rate of return is 9% after tax, the minimum after-tax cash flow forever is $105,000 times 9% = $9,450.

The above answer is correct, but tell your teacher he is ignorant.

a) There is no limit to a MAXIMUM acceptable cash flow, and

b) Why give the TAX RATE 40%, when it is not needed in the calculation? Deliberate confusion of students is not allowed, but I suspect he is confused himself. (Unless of course, you copied the questions wrongly yourself!)

As the other two answerers have astutely noted, the question as worded doesn't make any sense. I'm going to assume you made a mistake and you meant "What is the MINIMUM after-tax cash flow that would make the investment acceptable to Ace."

This is a net present value (NPV) problem. If the project has a NPV < 0, then the project destroys value and should not be undertaken. If the project has an NPV > 0, then it adds value and should be undertaken. If the NPV = 0, then Ace is indifferent.

Given the implications of NPV, the investment would be acceptable to Ace if the NPV was greater than or equal to zero. Therefore, what we have to do is solve for the cash flow that would yield an NPV of zero. That cash flow, or any greater cash flow, would make the project acceptable.

The equation looks like this:

NPV = [Cash flow * (1-Tax rate)]/discount rate - initial investment

The cash flow times 1 minus the tax rate gives us the after-tax cash flow. This property yields money forever, so this is a perpetuity, and the present value of a perpetuity beginning at T=1 is just the cash flow divided by the discount rate. Then we just subtract out the cost of the investment.

Plug in the numbers and it looks like this:

0 = [X*(0.6)]/0.09 - 105,000

We're solving for the cash flow. If you do the math:

X = $15,750

That means that if the per-period cash flow from this investment is $15,750, the NPV of the project will be exactly 0. An NPV of 0 isn't bad; it just means that there was no change in value at all. If we go even one dollar above $15,750, the project starts to actually create value. Even one dollar less than this number begins to destroy value. As such, the investment becomes acceptable to Ace if the per-period cash flow is $15,750 or greater.