Blue Angel, Inc., a private firm in the holiday gift industry, is considering a
ID: 2738736 • 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 1.70. The market risk premium is 6 percent, and the risk-free rate is 4 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 $692,000 and is expected to result in a $112,000 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 4 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
1) Calculation of NPV of this project :
Using CAPM Approach,
Cost of equity = 4% + 1.70 * 6%
= 14.2%
Cost of debt after tax = 2.6% (4% - 35%)
Target debt equity ratio = 0.45
WACC = 0.55*14.2% + 0.45*2.6%
= 0.0781+0.0117
= 9%
Debt portion in initial outlay = $311,400 (692000*45%)
Calculation of Net operating cash flow :
Calculation of present value of Projected cash flows :
Terminal cash flow = 77069 /0.09
= 856322
Present value of terminal cash flow = 856322 * 0.650
= $556610
NPV = 556610 - 418704
= $137906
Particulars 1 2 3 4 5 6 Cash Inflow 112000 116480 121140 125985 131024 131024 Less :Interest@4% (12456) (12456) (12456) (12456) (12456) (12456) Profit before tax 99544 104024 108684 113529 118568 118568 Less : Tax@35% (34840) (36408) (38040) (39735) (41499) (41499) Net operating cash flow 64704 67796 70644 73794 77069 77069