Question

Caribbean, Inc. is considering a new investment opportunity. The project requires an initial outlay of $525,000 and is expected to bring in a $75,000 cash inflow at the end of the first year. After the first year, annual cash flows from the project are forecasted to grow at a constant rate of 5% until the end of the fifth year and to remain constant forever thereafter.

The company currently has a target debt-to-equity ratio of .40, but the industry that the company operates in has a debt-to-equity ratio of .25. The industry average beta is 1.2, the market risk premium is 7%, and the risk-free rate is 5%. Assume that all the companies in the industry can issue debt at the risk-free rate and the corporate tax rate is 40%.

Assuming that the project will be financed at Caribbean’s target debt-to-equity ratio, should the company invest in the project?

Answer 1

1)	The first step is to unlever the industry equity beta.
	Unlevered beta = Levered beta/[1+(1-t)*D/E]
	Unlevered beta = 1.2/(1+0.6*0.25) =			1.04
2)	The second step is to relever the unlevered beta
	at (1) above to Carribean Inc's target D/E.
	Levered beta = Unlevered beta*[1+(1-t)*D/E]
	Levered beta for Carribean = 1.04*(1+0.6*0.4) =			1.29
3)	Cost of equity for Carribean = 5%+1.29*7% =			14.03%
4)	After tax cost of debt = 5%*(1-40%) =			3.00%
5)	WACC of Carribean = 14.03%*1/1.4+3.00%*0.4/1.4 =			10.88%
6)		0	1	2	3	4	5
	Cash inflow		$       75,000	$        78,750	$      82,688	$   86,822	$        91,163
	PVIF at 10.88% [PVIF = 1/1.1088^n]	1	0.90188	0.81338	0.73357	0.66159	0.59667
	PV at 10.88%		$       67,641	$        64,054	$      60,657	$   57,440	$        54,394
	Sum of PV of CF t1 to t5	$ 3,04,186
	Terminal value of FCF = 91163/0.1088 =						$    8,37,895
	PV of terminal value = 837895*0.59667 =	$ 4,99,947
	Total PV of cash inflows	$ 8,04,132
	Less: Initial outlay	$ 5,25,000
	NPV	$ 2,79,132
	Decision:
	As the NPV is positive, the firm can invest in the project.