Blue Angel, Inc., a private firm in the holiday gift industry, is considering a
ID: 2648907 • 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
Re= Rf + (Rm-Rf)*Beta Rf= 5% Rm= 7% Beta= 1.2 Hence, Re= 7.4% Initial outlay= $675000 Target debt equity ratio= 0.40 Hence, amount borrowed= 0.40*$675000= $270000 Interest @ Rf= 5% Thus, Interest every year= 5%*$270000= $13500 However after tax shield, interest= 5(1-0.40)= 3% Hence, after tax interest= 3%*$275000= $8100 Annual Cash Flows= $95000-$8100= $86900 If growth rate of cash flows is 5%, cash flows shall be: First 5 years Year Cash flows PV Factor@ 7.4% Present Value 1 86900.00 0.9311 80912.48 2 91245.00 0.8669 79104.38 3 95807.25 0.8072 77336.68 4 100597.61 0.7516 75608.49 5 105627.49 0.6998 73918.91 Total 386880.93 Horizon Period- beyond 5 years Cash flow at the Year 5 105627.49 Growth 5% Cash flow at the Year 6 110908.87 Re 7.40% Hence, Present Value of Future cash flows at the end of Year 5: Cash flow at the Year 6/ Re-g 4621202.82 Hence, Present Value 3233952.4 Total 3620833.33 Less: Initial Investment 675000.00 NPV 2945833.33