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 1.40. 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 34 percent. The project requires an initial outlay of $677,000 and is expected to result in a $97,000 cash inflow at the end of the first year. The project will be financed at the company'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 answer to 2 decimal places, e.g., 32.16.) NPV $

Answer 1

1]	Unlevering equity beta of industry:
	Unlevered equity beta = Levered equity beta/[1+(1-t)*D/E
	= 1.40/(1+0.66*0.35) =	1.14
2]	The second step is to relever the unlevered industry equity beta to suit the target debt equity ratio of Blue Angel.
	Levered equity beta = Unlevered equity beta*[1+(1-t)*D/E
	= 1.14*(1+0.66*0.40) =	1.44
3]	Cost equity of Blue Angel per CAPM = 5%+1.44*7% =	15.08%
	After tax cost of debt of Blue Angel = 5%*(1-34%) =	3.30%
	WACC of Blue Angel at target debt equity ratio = 3.30%*0.40/1.4+15.08%*1/1.4 =	11.71%
	Note:
	As target debt equity ratio is 0.40, debt is 0.40 and
	equity is 1. So weight of debt = 0.40/1.4 and weight
	of equity is 1/1.4.
	4] 0 1 2 3 4 5 Cash inflow $     97,000.00 $ 1,01,850.00 $ 1,06,942.50 $   1,12,289.63 $   1,17,904.11 PVIF at 11.71% [PVIF = 1/1.1171^t] 0.89518 0.80134 0.71734 0.64214 0.57483 PV of cash inflow $     86,831.98 $      81,616.31 $     76,713.92 $       72,106.00 $      67,774.87 Sum of PV of cash inflows - t1 to t5 $   3,85,043.07 Continuting value of cash inflows = 117904.11/11.71% = $10,06,866.87 PV of continuing value = 117904.11*0.57483 = $   5,78,777.70 PV of cash inflows $   9,63,820.77 Less: Initial outlay $   8,65,000.00 NPV $       98,820.77