Blue Angel, Inc., a private firm in the holiday gift industry, is considering a

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 .30. The industry average beta is 1.90. The market risk premium is 6 percent, and the risk-free rate is 4 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 34 percent. The project requires an initial outlay of $682,000 and is expected to result in a $102,000 cash inflow at the end of the first year. The project will be financed at Blue Angel’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.

Explanation / Answer

Ans)

Tax rate = 34%

2.57523

Period

Cash flow

DCF@ 12%

Present value

NPV of the project =

299571$

Curent Company target Debt Equity ratio = 0.35 Industry target debt equity ratio = 0.3 Avg industry beta = 1.9 Market risk premium = 6% Risk free rate = 4% Kd = 4%

Tax rate = 34%

6th to forever thereafter CF(1+g)/Ke-g 1034158.7 WACC Ke *Wa+Kd(1-t) Wb 12 Ke= Rf+Beta *Risk premium 16% Beta equity of security = Beta equity of industry*Equity weight/(Equity weight+debt weight(1-tax)) = 2.57523*0.70/.70+0.30*(1-0.34) = 2 Beta assets of industry = Beta equity of industry*Equity weight/(Equity weight+debt weight(1-tax)+Beta of debt*debt weight/(Equity weight+debt weight(1-tax)) Beta equity of industry= 1.90*{0.65+0.35*(1-0.34)}/0.65

2.57523

Period

Cash flow

DCF@ 12%

Present value

Initial outflow(0th yr) -682000 1 -682000 1 102000 0.8929 91071 2 106080 0.7972 84566 3 110323 0.7118 78526 4 114736 0.6355 72917 5 119326 0.5674 67709 6th to forever thereafter 1034159 0.5674 586782

NPV of the project =

299571$

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