Blue Angel, Inc., a private firm in the holiday gift industry, is considering a
ID: 2648892 • Letter: B
Question
Blue Angel, Inc., a private firm in the holiday gift industry, is considering a new project. The company currently has a target debtequity ratio of .40, but the industry target debtequity ratio is .35. The industry average beta is 1.2. The market risk premium is 7 percent, and the risk-free rate is 5 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 40 percent. The project requires an initial outlay of $675,000 and is expected to result in a $95,000 cash inflow at the end of the first year. The project will be financed at Blue Angels target debtequity ratio. Annual cash flows from the project will grow at a constant rate of 5 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))
Blue Angel, Inc., a private firm in the holiday gift industry, is considering a new project. The company currently has a target debtequity ratio of .40, but the industry target debtequity ratio is .35. The industry average beta is 1.2. The market risk premium is 7 percent, and the risk-free rate is 5 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 40 percent. The project requires an initial outlay of $675,000 and is expected to result in a $95,000 cash inflow at the end of the first year. The project will be financed at Blue Angels target debtequity ratio. Annual cash flows from the project will grow at a constant rate of 5 percent until the end of the fifth year and remain constant forever thereafter.
Explanation / Answer
Given
Industry Debt Equity Ratio = 0.35
Beta of Industry = 1.2
Comapny Debt Equity Ratio = 0.4
Beta of Company = 1.2 * 0.4/0.35 = 1.37
Also , Risk free rate (Rf) = 5 %
Market Premium (Rm) = 7 %
So Cost of Equity = Rf + (Rm - Rf)*Beta
= 5 % + ( 7 % - 5 %) * 1.37
= 7.74 %
Cost of Debt = 5 % * (1 - 0.40) = 3 %
Weight of Debt = 1
Weight of Equity = 2.5 (As debt Equity Ratio is 0.40)
Weighted Average Cost of Capital (WACC) = (3 % * 1 + 7.74 % * 2.5)/3.5
= (0.03 + 0.1935)/3.5 = 0.0639 = 6.39 %
Net Present Value =Present Value of Cash Inflow - Present Value of Cash Outflow
= 1611400.08 - 675000
= $ 936400.08
Year Cash Flow Amount Discount Factor Present Value 1 95000 * 1 95000 1.0639 89294.11 2 95000 * 1.05 99750 1.1356 87838.50 3 99750 * 1.05 104737.50 1.2082 86690.88 4 104737.50 * 1.05 109974.40 1.2854 85558.25 5 109974.40 * 1.05 115473.10 1.3675 84440.42 6 & 1713251 1.4549 1177577.94 Total Inflow = 1611400.08