GeKay Inc. is considering a new $30m project. Its CFO, Mr. Smith, has brought you in as a consultant to advise him as to whether the project should be undertaken. First, you note that this project would have the same risk as that of GeKay's existing businesses. Further, you estimate the project's unlevered pre-tax cash flows to be $3m per year indefinitely. Mr. Smith has already decided that if he undertakes the project, he will finance the entire $30m with a new issue of 10-year bonds, at the company's pre-tax cost of debt of 6%. He also assumes that he will keep refinancing this debt indefinitely with new debt issues. Do you advise him to undertake the project? Additional data is given below:
GeKay's common stock outstanding = 10m shares
GeKay's capitalization = $500m
GeKay s (levered) β = 0.80
GeKay's c target debt ratio =0.35
GeKay's tax rate = 35%
Risk-free rate = 4%
The market's equity risk premium = 5%