Question

Smart Stack Inc. is in the book shelf manufacturing business. The corporate tax rate is 21 percent.

The VP of R&D 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.

Smart Stack, 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.

Should Smart Stack invest in the project?

Answer 1

Calculating unlevered beta using industry levered beta

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

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

Unlevered Beta = 0.94

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

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

Levered Beta = 1.24

Cost of equity = Rf + (Beta * Market 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%

Source	Weightage	Cost	Weightage * Cost
Debt	0.29	3.95%	1.13%
Equity	0.71	13.68%	9.77%
WACC = 1.13% + 9.77%
WACC = 10.90%

Year	Cash flow	Present value calculation	Present value
0	-785000		-7,85,000
1	93000	93000 / (1+10.90%)^1	83,859
2	97650	97650 / (1+10.90%)^2	79,398
3	1,02,533	102533 / (1+10.90%)^3	75,174
4	1,07,659	107659 / (1+10.90%)^4	71,174
5	1,13,042	113042 / (1+10.90%)^5	67,388
Terminal value	10,37,083	1037083 / (1+10.90%)^5	6,18,238
		NPV	2,10,232

As PV of Cash flow is 210,232 company should accept this project.