Question

Blue Angel, Inc., a private firm in the holiday gift industry, is considering a new project. The company currently has a target debt–equity ratio of .40, but the industry target debt–equity ratio is .35. The industry average beta is 1.2. The market risk premium is 7 percent, and the risk-free rate is 5 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 40 percent. The project requires an initial outlay of $675,000 and is expected to result in a $95,000 cash inflow at the end of the first year. The project will be financed at Blue Angel’s target debt–equity ratio. Annual cash flows from the project will grow at a constant rate of 5 percent until the end of the fifth year and remain constant forever thereafter. Calculate the NPV of the project. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) NPV $

Answer 1

Debt Is issed at risk free, So,

before tax cost of debt = risk free rate = 5%

Tax rate = 40%

After tax cost of debt = 5% × (1 - 40%)

= 3%

After tax cost of debt is 3%.

Industry Beta = 1.20

Industry Debt Equity ratio = 0.35

Now calculated unlevered beta using following formula:

Unlevered beta = beta (levered) / 1 + (1 - tax rate) x (Debt/Equity)

                         = 1.20 / [1+ (1 – 40%) × (35%)]

                         = 1.20 / [1+ 0.21]

                         = 0.99

Unlevered beta is 0.99.

Debt Equity ratio of company = 0.40

So, Levered beta of company is calculated in excel and screen shot provided below:

Levered beat = unlevered beta × [1 + (1 - tax rate) x (Debt/Equity)]

                      = 0.99 × [1+ (1 – 40%) × (40%)]

                      = 0.99 × [1+ 0.24]

                      = 1.23

So, Levered beta of company is 1.23.

Now,

Cost of equity = 5% + (7% × 1.23)

= 5% + 8.61%

= 13.61%

Cost of debt is 13.61%.

Debt equity ratio = 0.40

Weight of debt = 29%

Weight of equity = 71%

Now, WACC is calculated below:

WACC = (26% × 3%) + (74% × 13.40%)

= 0.86% + 9.72%

= 10.58%

WACC of project is 10.58%.

Now NPV of project at 10.58% discount rate is calculated in excel and screen shot provided below:

NPV of project is $373,711.73.