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 .30, but the industry target debt–equity ratio is .25. The industry average beta is 1.40. The market risk premium is 8 percent, and the risk-free rate is 6 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 35 percent. The project requires an initial outlay of $689,000 and is expected to result in a $109,000 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 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 final answer to 2 decimal places. (e.g., 32.16))

Calculate the NPV of the project. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Explanation / Answer

1) Unlevering the Industry average beta & and relevering it for the firms target debt ratio:

As the target debt ratio of the firm of 0.30 is different from the industry average debt ratio of 0.25 changes the industry average beta has to be unlevered and then releved to get the beta of the project.

formula for unlevering the beta =

Unlevered Beta = Levered Beta / (1 + ((1 – Tax Rate) x (Debt/Equity)))

= 1.4/[1+(1 - 0.35)*0.25} = 1.4/1.1625 = 1.2043

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

1.2043*[1+(0.65*0.3) = 1.4391 = 1.44

2) WACC for the project:

After tax Cost of debt = 6*(1 - 0.35) = 3.9%

Cost of equity as per CPM = Risk free rate + beta*market risk premium = 6 + 1.44*8 = 17.52%

WACC = 3.9*0.3 + 17.52*.7 = 1.17 + 12.26 = 13.43%

3) NPV of the project:

from 1 2 3 4 5 6th year cash inflow 109000.00 115540.00 122472.40 129820.74 137609.99 137610.00 Horizon value = 137610/0.1343 1024646.31 pvif @ 13.43% 0.8816 0.7772 0.6852 0.6041 0.5325 0.4695 PV 96094.51 89800.03 83917.87 78421.00 73284.19 481067.91 Cumulative PV 902585.51 Initial outlay 689000.00 NPV of the project 213585.51

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