MHRM 6101: Foundations in Human Resource Management

MHRM 6101: Foundations in Human Resource Management

Blue Angel, Inc., a private firm in the holiday gift industry, is considering a new project. The company currently has a target debt to equity ratio of .48, but the industry target debt”?oequity ratio is .38 The industry average beta is 1.1. The market risk premium is 8 percent, and the risk-free rate is 5.7 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 55 percent. The project requires an initial outlay of $485,000 and is expected to result in a $90,000 cash inflow at the end of the first year. The project will be financed at Blue Angel’s target debt”?oequity ratio. Annual cash flows from the project will grow at a constant rate of 5.7 percent until the end of the fifth year and remain constant forever thereafter.

Required:

(a) Calculate net present value. (Do not include the dollar sign ($). Negative amount should be indicated by a minus sign. Round your answer to 2 decimal places. (e.g., 32.16))

Net present value $ ______________

(b) Should Blue Angel invest in the project? (Yes/No)

Solution:

Industry Debt to equity ratio = 0.38 [We would use industry debt to equity ratio as the Beta is based on industry data]

Debt to total capital, Wd = 0.38 / 1.38 = 0.28

Equity to total capital, We = 1 – 0.28 = 0.72

Computing cost of capital (WACC)

Industry average beta = 1.1

Market risk premium, (Rm-Rf) = 8%

Risk-free rate, Rf = 5.7%

Cost of equity (CAPM) = Rf + Beta*(Rm-Rf)

Cost of equity, Ke = 5.7% + 1.1*8% = 14.50%

Cost of debt, Kdt = risk-free rate = 5.7%

Corporate tax rate, t = 55%

Post-tax cost of debt, Kd = Kdt*(1-t) = 5.7%*(1-55%) = 2.565%

 WACC = Ke*We + Kd*We

WACC = 0.28*2.565% + 0.72*14.50% = 11.21%

Project cash flows

CFo = -$485,000

CF1 = $90,000

CF2 = $90,000*(1+5.7%) = $95,130.00

CF3 = $95,130.00*(1+5.7%) = $100,552.41

CF4 = $100,552.41*(1+5.7%) = $106,283.90

CF5 = $106,283.90*(1+5.7%) = $112,342.08

Terminal cash flow (TCF) = CF5 / WACC = $112,342.08 / 11.21% = $1,001,842.17

NPV of the project = CFo / (1+WACC)^0 + CF1 / (1+WACC)^1 + CFn / (1+WACC)^n + TCF / (1+WACC)^n

NPV of the project = -485,000 / (1+11.21%)^0 + $90,000.00 / (1+11.21%)^1 + $95,130.00  / (1+11.21%)^2 + $100,552.41  / (1+11.21%)^3 + $106,283.90  / (1+11.21%)^4 + $112,342.08  / (1+11.21%)^5 + $1,001,842.17 / (1+11.21%)^5

NPV of the project = $470,305.61

Since the NPV of the project is positive, the project should be Accepted.

MHRM 6101: Foundations in Human Resource Management MHRM 6101: Foundations in Human Resource Management