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 21 percent. The project requires an initial outlay of $785,000 and is expected to result in a $93,000 cash inflow at the end of the first year. The project will be financed at the company'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. Should the company invest in the project? Show all workings.

Answer 1

Unlevered Beta = Equity Beta / (1+(Debt / Equity)*(1 - Tax rate))

Unlevered Beta = 1.2 / (1+(0.35)*(1 - 21%))

Unlevered Beta = 0.94

Blue Angel Levered Beta = Unlevered Beta * [1 + (1 – Tax Rate) * (Debt / Equity)]

Blue Angel Levered Beta = 0.94 * (1 + (1 - 21%) * (0.40))

Blue Angel Levered Beta = 1.24

Cost of equity = Risk free rate + (Beta * Market risk premium)

Cost of equity = 5% + (1.24 * 7%)

Cost of equity = 13.68%

Post tax cost of debt = Pre tax cost of debt * (1 - tax rate)

Post tax cost of debt = 5% * (1 - 21%)

Post tax cost of debt = 3.95%