Question

Blue Angle, Inc., a private firm in the holiday gift industry, is considering a new project. The company currently has a target debt-equity ratio of 0.40, but the industry average debt-equity ratio is 0.35. The industry average beta is 1.25. 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 750,000 and is expected to result in a $105,000 after-tax cash inflow at the end of the first year. The project will be financed at Blue Angle’s target debtequity ratio. Annual cash flows from the project will grow at a constant rate of 5 percent until the end of fifth year and remain constant forever thereafter. Should Blue Angel invest in this project?

Answer 1

Calculation of Beta From Industry average beta to Blue angle Inc Beta:-

Industry average beta = 1.25

unlevered beta = Levered beta / [ 1+ ( 1- tax rate) * ( debt / equity)]

= 1.25 / [ 1+ ( 0.60) * 0.35)] = 1.25 / 1.21

Unlevered beta = 1.0331

levered beta for blue angle inc = unlevered beta * [ 1+ ( 1- tax rate) * ( debt / equity)]

= 1.0331 * [ 1 + 0.60 * 0.40]

levered beta for blue angle inc = 1.281

Cost of equity = Rf + Beta * market risk premium

= 5% + 1.281 * 7%

cost of equity = 13.967%

Cost of debt after tax = 5% * (1 - tax rate) = 5% * 0.60 = 3%

Debt to equity = 0.40 = 2/5

debt weight = 2/7

equity weight = 5/7

WACC = cost of debt after tax * weight of debt + cost of equity * weight of equity = 3% * 2/7 +13.967% * 5/7 = 0.857% + 9.976%

WACC = 10.833%

Free cash flows upto 5 years.

Years	cash flows	Calculation
1	105,000
2	110250	105,000 * 1.05
3	115762.5	110,250 * 1.05
4	121550.625	115,762.5 * 1.05
5	127628.1563	121,550.625 *1.05

cash inflows from sixth years is constant forever that is $ 127,628.1563 per year

Present value of cash inflows from year 6 onwards,at the end of year 5 = 127,628.1563 / 10.833% = 127,628.1563 / 0.10833

Present value of cash inflows from year 6 onwards,at the end of year 5 =$ 1,178,142.2832

in 5 th years total cash flows = $ 127,628.1563 + 1,178,142.2832 =$ 1,305,770.4395

Present value of cash inflows

Years	cash flows	[email protected]%	[email protected]%
1	105,000.0000	0.90225835	94,737.1270
2	110,250.0000	0.81407013	89,751.2324
3	115,762.5000	0.73450158	85,027.7390
4	121,550.6250	0.66271018	80,552.8371
5	1,305,770.4395	0.59793580	780,766.8916
present value of cash inflows	1,130,835.8272

NPV = present value of cash inflows - initial investment

= $ 1,130,835.8272 -  750,000

NPV =$  380,835.8272

here NPV is positive , so we accept the project