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 debt-

equity 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

Sol:

Calculation of weightage average cost of capital (WACC)-

(a) Cost of equity as per CAPM model

Cost of equity(Ke) = Risk free rate of return+(Risk premium *Beta)

= 5+(7*1.25)

= 13.75

(b) Cost of Debt (Kd)-

Kd =Interest rate (1-Tax rate)

= 5 (1-0.4)

= 3

        (C) Equity and Debt ratio for WACC

              Assume that debt portion is 1

                Debt to equity ratio = Debt/ Equity

                                0.4 = 1/equity   

                                Equity = 1/0.4

                                Equity = 2.5

        WACC = (Ke* equity ratio)+ (Kd* Debt Ratio)

                           = (13.75*2.5/3.5) + (3*1/3.5)

                         = 10.68%

Calculation of Present value of cash flow

                Intial cash outflow           = $750000

(-) Portion of Equity investment = $535714

Debt portion in investment            $214286

Interest cost of debt after tax = 214286*3%

                                                                = 6429

Cash inflow after tax and interest = 105000-6429

                                                                = 98571

Year	Cash inflow	growth factor	cash flow with growth rate	PVF @ 10.68%	Present value
1	98571	1.00	98571	0.904	89059
2	98571	1.05	103500	0.816	84489
3	98571	1.10	108675	0.738	80153
4	98571	1.16	114108	0.666	76040
5	98571	1.22	119814	0.602	72137
				(A)	401879

Terminal value of cash flow for remaining years

= 119814/0.1068 = 11,21,854

Present value of terminal cash flow = 1121854*0.602

                                                                = $675,356 (B)

Total Present value of cash inflows (A+B) = 401879+675356

                                                                                = $10,77,235

Present value of cash inflow is higher than intial investment, so that Blue angel should invest in this project.