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 .65, but the industry target debt-equity ratio is .70. The industry average beta is 1.05. The market risk premium is 6.6 percent and the risk-free rate is 4.6 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 25 percent. The project requires an initial outlay of $860,000 and is expected to result in a $108,000 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

Variables given :

Debt Equity Ratio = 0.65

Industry Debt Equity Ratio = 0.70

Industry Average Beta = 1.05

Market risk premium = 6.6 %

Risk-free rate = 4.6 %

Tax Rate @ 25 %

We need to find the beta of Blue Angel Inc. For this, we need to deleverage and relaverage the industry beta.

U = L / (1 + D/E(1 - t))

Where,

U is the beta of the unlevered firm

L is the beta of the levered firm

D/E is the Debt Equity Ratio of Levered Firm

t is the tax rate

U= 1.05 / 1 + 0.70 ( 1 - 0.25 )

U = 1.05 / 1.525

U = 0.6885

Now, we releverage using the Debt Equity Ratio of Angel Inc.

L = U * (1 + D/E(1 - t))

=0.6885 * (1+ 0.65 (1- 0.25)

= 1.0241

Next we find the Required rate of return

Re= Rf + Beta (Rm- Rf)

= 4.6 + 1.0241( 6.6)

= 11.36 %

The Project has two phases

1. Growth phase for five years

Years	Inflow	PVF @ 11.36%	PV of cash inflows
1	1,08,000.00	0.8980	96,982.76
2	1,14,480.00	0.8064	92,314.77
3	1,21,348.80	0.7241	87,871.46
4	1,28,629.73	0.6503	83,642.01
5	1,36,347.51	0.5839	79,616.14
			4,40,427.13

2.No growth stage inflow remains the same forever

=1,36347.51 / 0.1136

= 12,00,242

PV of cash flow = 12,00,242 * 0.5839 = 7,00,821.4

Total PV of cash flow = 4,40,427.13 + 7,00,821.4

= 11,41,248.53

(-) Initial outflow = 8,60,000.00

NPV of Project = 2,81,248.53