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 .70, but the industry target debt-equity ratio is .65. The industry average beta is 1.10. The market risk premium is 6.9 percent and the risk-free rate is 4.9 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 22 percent. The project requires an initial outlay of $845,000 and is expected to result in a $105,000 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 6 percent until the end of the fifth year and remain constant forever thereafter. Calculate the NPV of the project.

Answer 1

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

1.1 = Beta unlevered *(1 + (1-0.22)* 0.65)

Beta unlevered= 0.7299

Levered Beta for company = 0.7299 * (1 +(0.78)*(0.7)) = 1.12842

Cost of equity = 4.9 + 6.9 * 1.12842 = 12.686135%

Cost of debt = 4.9 %

Wd = 0.7 /1.7 = 0.41176

We = 1 / 1.7 = 0.58824

WACC = 0.58824 * 12.686135 + 0.41176 * 4.9 *(1-0.22 ) = 9.036179 %

Cash flows of the company would be :

Year 0 = -$845,000

Year 1 = $105,000

Year 2 =$105,000  x 1.06= $111300

Year 3 = $111300x 1.06 = $117978

Year 4 = $117978 x 1.06 = $125056.68

Year 5 = $125056.68x 1.06 = $132560.0808

Year 6 = $132560.0808 and so on.

Terminal Value = $132560.0808 / 0.09036179 =$1466992.639

NPV of the project = $ 562045.43 Answer