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Fucciani Fashions, Inc., is in the formal wear clothing industry. The corporate tax rate is 21...

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?

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Expert Solution

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.

jeff jeffy answered 1 year ago
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