Problem 18-18 Projects That Are Not Scale Enhancing Blue Angel, Inc., a private
ID: 2738078 • Letter: P
Question
Problem 18-18 Projects That Are Not Scale Enhancing
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 .40, but the industry target debt–equity ratio is .35. The industry average beta is 1.60. 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 $679,000 and is expected to result in a $99,000 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 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))
NPV $
Explanation / Answer
Unlevered Beta of industry = Levered Beta (1+(1-t)*D/E) = 1.6(1-0.4)*0.35 = 1.936
Levered beta of Blue Angel = Unlevered Beta/(1+(1-t)D/E) = 1.936/(1+(1-0.4)*0.4) = 1.56
Cost of capital of Blue Angel = 5+1.56*7 = 15.93%
NPV= $226,763.41
Year Cash Inflow cash Outflow Value of Cash flow after 5th year Total Cash flow DF @15.93% PV 0 -679000 -679000 1 -679000 1 99000 99000 0.863 85396 2 103950 103950 0.744 77345 3 109148 109147.5 0.642 70053 4 114605 114604.9 0.554 63448 5 120335 1156009 1276344 0.478 609521 NPV 226763.41 Value of Cash flow after 5th year =120335*(1+0.05)/(0.1593-0.05) 1156009