Blue Angel Inc. is a private firm in the holiday gift industry considering a new
ID: 2675073 • Letter: B
Question
Blue Angel Inc. is a private firm in the holiday gift industry considering a new project. The company currently has a target debt-equity ratio of .38, but the industry target debt-equity ratio is .28. The industry average beta is 1.6. The market risk premium is 5 percent, and the risk-free rate is 5.7 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 $490,000 and is expected to result in a $86,000 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 7.4 percent until the end of the fifth year and remain constant forever thereafter. Using the WACC method, calculate the NPV.Explanation / Answer
Bu = Bl / [ 1 + (1-t)(D/E) ] First unlevered beta needs to be calculated using industry average beta Bu = 1.6/(1+0.6*.28) =1.369863014 Now, the levered beta is calculated using target debt-equity ratio of .38 1.369863014 = Bl/(1+0.6*.38) Bl = 1.682 Cost of equity Re = Rf + Bl*(Rm-Rf) =5.7+ 1.682*5 =14.11% WACC = 14.11*(1/1.38) + 5.7*(.38/1.38)*0.6 = 11.166% NPV = -$490,000 + $86,000/(1+11.166%) + $86,000*1.074/(1+11.166%)^2 + $86,000*(1.074^2)/(1+11.166%)^3 + $86,000*(1.074^3)/(1+11.166%)^4 + $86,000*(1.074^4)/(1+11.166%)^5 + ($86,000*(1.074^5)/11.166%)/(1+11.166%)^5 = $519,753.3562