Blue Angel, Inc., a private firm in the holiday gift industry, is considering a
ID: 2739075 • 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 .40, but the industry target debt–equity ratio is .35. The industry average beta is 1.50. 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 35 percent. The project requires an initial outlay of $683,000 and is expected to result in a $103,000 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))
Explanation / Answer
Industry Data D/E = 0.35 Rs = Rf + beta * (Rm - Rf) Rs = 0.05 + 1.50*(0.07-0.05) Rs = 0.08 Rs = 8% Rs = Ro + 0.35*(Ro-Rb)(1-t) 0.08 = Ro + 0.35*(Ro-0.05)(1-0.35) 0.08 = Ro + 0.2275(Ro-0.05) 0.08 = Ro + 0.2275Ro -0.011375 0.08 = 1.2275Ro -0.011375 0.091375 = 1.2275Ro Ro =7.44% Blue Angel Rs = 7.44% + 0.40*(7.44%-5%)(1-0..35) Rs = 0.0744 + 0.006344 Rs = 0.080744 Rs = 8.07% NPV = -683000 + 103000*1/(8.07%-5%)*(1-(1+5%)^5/(1+8.07%)^5)+103000*(1+5%)^5*1/8.07%*1/(1+8.07%)^5 NPV = 872282.80