Blue Angel, Inc., a private firm in the holiday gift industry, is considering a
ID: 2738666 • 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 .45, but the industry target debt–equity ratio is .40. The industry average beta is 1.30. 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 $676,000 and is expected to result in a $96,000 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))
Explanation / Answer
Debt equity ratio =Debt /equity
= .45 /1
weight of debt = .45 /(1+.45) =.45 /1.45 = .3103
weight of equity = 1 /1.45 = .6897
Cost of equity =Rf + [Beta*Market premium]
= 6 + [1.3*8]
= 6+ 10.4 = 16.4%
Cost of capital =(After tax cost of debt *weight of debt)+ (cst of equity* weight of equity)
= (6 *(1-.35) * .3103) +(16.4* .6897)
= 1.2102+ 11.3111
= 12.5213% (approx 12.52%)
CF 2 = CF1 (1+G) = 96000(1+.06)= 101760
CF3 = 101760(1+.06)= 107865.6
CF4 = 107865.6(1+.06) = 114337.54
CF5 = 114337.54 (1+.06) =121197.79
Terminal value at year 5 = 121197.79/.1252 = 968,033.45
Present value of cash flow =(PVF@12.52%,1*CF1)+(PVF@12.52%,2*CF2)......(PVF@12.52%,5*Terminal value)
(.88873* 96000)+(.78984*101760)+(.70196*107865.6)+(.62385*114337.54)+(.55444*121197.79)+(.55444*968033.45)
= 85318.08+ 80374.12+ 75717.34+ 71329.47+ 67196.90+ 536716.47
= 916652.38
NPV =persent value -InitiAL investment
= 916,652.38 - 676000
= 240,652.38