Question

Fucciani Fashions, Inc., is in the formal wear clothing industry. The corporate tax rate is 21 percent. The CEO has proposed a new venture. 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. The company currently has a target debt-equity ratio of 0.40, but the industry target debt-equity ratio is 0.35. The industry average beta is 1.2. The market risk premium is 7 percent and the risk-free rate is 5 percent. Fucciani, like all other firms is this industry, can borrow at the riskless interest rate. All companies in this industry can issue debt at the risk-free rate.

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Should Fucciani invest in the project?

Answer 1

Beta levered = Beta unlevered * ( 1 + (1-t) *(D/E))

1.2 = Beta unlevered *(1 + (1-0.21)* 035)

Beta unlevered= 0.94007

Levered Beta for company = 0.94007 * (1 +(0.79)*(0.4)) = 1.23713212

We will calculate cost of equity using CAPM.

Cost of equity = Rf + Levered Beta for company * market risk premium

Cost of equity = 5 + 7 * 1.23713212= 13.6599%

Cost of debt = 5 %

Wd = 0.4 /1.4 = 0.28571

We = 1 / 1.4 = 0.71429

WACC = We*cost of equity + Wd *cost of debt *(1-tax rate)

WACC = 0.71429* 13.6599+ 0.28571* 5 *(1-0.21 ) = 10.88568%

Cash flows of the company would be :

Year 0 = -$785,000

Year 1 = $93,000

Year 2 =$93000 x 1.05= $97650

Year 3 = $97650 x 1.05 = $102532.5

Year 4 = $102532.5 x 1.05 = $107659.125

Year 5 = $107659.125 x 1.05 = $113042.0813

Year 6 = $113042.0813 and so on.

Terminal Value = $113042.0813 / 0.1088568=$1038447.587

NPV of the project = $ 211585.84 Answer

As the NPV is positive Fucciani should invest in the project.