Blue Angel, Inc., a private firm in the holiday gift industry, is considering a
ID: 2738625 • 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–equity ratio of .30, but the industry target debt–equity ratio is .25. The industry average beta is 1.40. The market risk premium is 8 percent, and the risk-free rate is 6 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 35 percent. The project requires an initial outlay of $689,000 and is expected to result in a $109,000 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 6 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 debt–equity ratio of .30, but the industry target debt–equity ratio is .25. The industry average beta is 1.40. The market risk premium is 8 percent, and the risk-free rate is 6 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 35 percent. The project requires an initial outlay of $689,000 and is expected to result in a $109,000 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 6 percent until the end of the fifth year and remain constant forever thereafter.
Explanation / Answer
Step 1 Calculation of WACC Nature of Fund Cost of Capital Weight Weighted Cost of Capital Debt 3.90% 0.23 0.90% Equity 17.2% 0.77 13.23% WACC 14.13% Note 1: Cost of debt(kd) = Interest Rate (1-Tax Rate) =6%(1-35%) =3.9% Note2: Cost of Equity(Ke) = Risk free return + beta(Market Premium) =6% + 1.4*8% =17.2% Step 2 Calculation of NPV Year Cash Flows Present value factor@ 14.13% Present Value 0 -689000.00 1.000 -689000.00 1 109000.00 0.876 95505.13 2 115540.00 0.768 88701.86 3 122472.40 0.673 82383.22 4 129820.74 0.589 76514.69 5 137609.99 0.516 71064.20 5 973885.27 0.516 502931.35 Net Present Value(NPV) 228100.45