Blue Angel, Inc., a private firm in the holiday gift industry, is considering a
ID: 2706989 • 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 debt
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 .48, but the industry target debt-equity ratio is .38 The industry average beta is 1.1. The market risk premium is 8 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 55 percent. The project requires an initial outlay of $485,000 and iexpected to result in a $90,000 cash inflow at the end of the first year. The project will be financed at Blue Angel's target debt-equity ratio. Annual cash flows from the project will grow at a constant rate of 5.7 percent until the end of the fifth year and remain constant forever thereafter. Required: Calculate net present value. (Do not include the dollar sign ($). Negative amount should be indicated by a minus sign. Round your answer to 2 decimal places. (e.g., 32.16)) Net present value $ Should Blue Angel invest in the project? (Yes/No)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
Yes we can invest