Blue Angel, Inc., a private firm in the holiday gift industry, is considering a
ID: 2756830 • 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 1.60. 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.
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.
Explanation / Answer
Target debt equity ratio : .40
Cost of equity: CAPM Model : risk free rate + Beta(Risk premium)
5 +1.6 * 7
16.20 %
Cost of debt : Risk free arte ie 5 %
After tax cost of debt : Interest ( 1 - Tax) = 5 (.3) = 3 %
Weighted average cost of capital : (Weigt of debt * debt rate)+ (Weight of equity * Equity rate) .4 * 3 + .6 * 16.2 = 10.92 %
Initial Investment : 679,000 /-
Year Cash inflows: PV factor @ 10.92 % PV of cash flows
1 99,000 .90155 89,253
2 103,950 .81279 84,490
3 109,148 .73277 79,980
4 114,605 .66063 75,712
5 120,335 .59559 71,670
unlimited period 1,101,970 .59559 656,322
Present value of cash inflows 1,057,427
Less; Initial Investment 6,79,000
NPV 378,427