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 .45, but the industry target debt-equity ratio is .40. The industry average beta is 1.10. The market risk premium is 6.1 percent and the risk-free rate is 4.7 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 $885,000 and is expected to result in a $113,000 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 4 percent until the end of the fifth year and remain constant forever thereafter.

Calculate the NPV of the project.

Answer 1

Answer:

Industry target debt-equity ratio is .40

The industry average beta is 1.10

The corporate tax rate is 25 percent.

Unlevered beta = Levered beta / (1 + (1 - tax rate) * (Debt / Equity)) = 1.10 / (1 + (1 - 25%) * (0.40 /(1 + 0.40))

= 1.10 / (1 + (1 - 25%) * (0.40 / (1 + 0.40))

= 0.9059

The company currently has a target debt-equity ratio of .45

Hence:

Levered beta = Unlevered beta * (1 + (1 - tax rate) * (Debt / Equity))

= 0.9059 * (1 + (1 - 25%) * (0.45 / (1 + 0.45))

= 1.12

Cost of equity = Risk free rate + Beta * Market risk premium = 4.7% + 1.12 * 6.1% = 11.53%

Cost of debt = Risk free rate = 4.7%

WACC = Cost of equity * Weight of equity + Cost of debt * (1- Tax rate) * weight of debt

= 11.53% * 1 / (1 + 0.45) + 4.7% * (1 - 25%) * 0.45 / (1 + 0.45)

= 9.05%

WACC of company = 9.05%

Project requires initial outlay of = $885,000

Year 1 cash flow = $113,000

Year 2 cash flow = 113000 * (1 + 4%) = $117520

Year 3 cash flow = 113000 * (1 + 4%) ² = $122220.80

Year 4 cash flow = 113000 * (1 + 4%) ³ = $127109.632

Year 5 cash flow = 113000 * (1 + 4%) ⁴ = $132,194.01728

From year 6 onwards cash flow will be constant at = $132194.01728

Value of project at the end of year 5 = Year 6 cash flow / WACC = 132194.01728 / 9.05% = $1,460,707.37

As such cash flows and NPV of the project are calculated as follows:

NPV of the project = $534,480.88