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 .35, but the industry target debt-equity ratio is .40. The industry average beta is 1.15. The market risk premium is 6.7 percent and the risk-free rate is 4.3 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 $815,000 and is expected to result in a $99,000 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. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Step1: We will calculate Beta unlevered so that we can convert it to Beta levered of the specific to the company using their D/E ratio.

Beta levered = Beta unlevered * ( 1 + (1-Tax) *(d/e))

1.15 = Beta unlevered *(1 + (1-0.21)* 0.4)

Beta unlevered= 0.87386

Levered Beta for company = 0.87386 * (1 +(1-0.21)*(0.35)) = 1.11548

Step2: We will calculate cost of equity using CAPM.

Cost of equity = 4.3 + 6.7 * 1.11548= 11.77373%

Cost of debt = 4.3 %

Wd = D / D+E

Wd = 0.35/1.35 = 0.259

We = E/ D+E

We = 1 / 1.35 = 0.741

Step3: We will calculate cost of capital using WACC

WACC = 0.741* 11.77373+ 0.259 * 4.3 *(1-0.21 ) = 9.604156 %

Step4: We will discount all the cash flow using cost of capital i order to calculate NPV.

Cash flows of the company would be :

Year 0 = -$815,000

Year 1 = $99,000

Year 2 =$99,000x 1.06= $104940

Year 3 = $104940*1.06 = $111236.4

Year 4 = $111236.4 * 1.06 = $117910.584

Year 5 = $117910.584 * 1.06 = $124985.219

Year 6 = $124985.219 and so on.

Terminal Value = $124985.219 / 0.09604156 = $1301365.982

NPV of the project = $430627.2948 Answer