Question

Doubleday Brewery is considering a new project.

The company currently has a target debt–equity ratio of .40, but the industry target debt–equity ratio is .25. The industry average beta is 1.08. The market risk premium is 8 percent, and the (systematic) risk-free rate is 2.4 percent.

Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 21 percent. The project will be financed at Doubleday’s target debt–equity ratio. The project requires an initial outlay of $5,400,000 and is expected to result in a $440,000 cash inflow at the end of the first year. Annual cash flows from the project will grow at a constant rate of 4.0 percent until the end of the eighth year before leveling off at that same annual level (no longer growing) forever thereafter. Using the WACC methodology, value this project and tell whether it should be pursued.

Answer 1

Answer to the question:

Given: Companies Debt equity Ratio = 0.40

            Industry’s debt equity ratio = 0.25

            Industry’s average beta = 1.08

            Market risk premium = 8%

            Risk Free rate of return = 2.40%

Tax rate = 21%

Initial Outflow = $5,400,000

Inflow = $440,000 and grow @4% till end of year 8 and thenafter no growth in cash flows

Evaluation of the project : Project is pursued if NAV of the project is positive

Year	Cash Flow	PV of Cash Flow @WACC 7.90%
1	$440,000	$407,785
2	$457,600	$393,046
3	$475,904	$378,839
4	$494,940	$365,146
5	$514,738	$351,948
6	$535,327	$339,227
7	$556,740	$326,966
8	$579,010	$315,148
After 8 years (Note 3 )	$7,329,240	$3,989,214
PV of all future Cash Flows		$6,867,319
Less: Initial Outflow		$5,400,000
NPV Of the project		$1,467,319

Conclusion: Since NPV of the project is positive, therefore the project should be pursued.

Note1 : Calculation of Beta of the company

First of all we have to calculate the unlevered beta of the company :

Unlevered Beta of company = Levered Beta of Industry

                                                            1 + D/E ratio (1-tax)

                                                     =    1.08

                                                            1+0.25(0.79)

                                                     = 0.9019

Levered Beta of Company = Unlevered beta of company * [1+D/E ratio (1-tax)]

                                                   = 0.9019 * [1+0.40*(0.79)]

                                                   = 1.1869

Note 2: Calculation of WACC

Cost of equity (Ke) as per CAPM = Risk free rate + Risk Premium * Beta

                                                   = 2.40 + 8 * 1.1869

                                                   =11.8952%

Cost of debt (Kd) = Interest rate (1-tax)

= 2.40*(0.79)

=1.896%

WACC= Weight of equity * Ke + Weight of debt *Kd

           = 0.60 * 11.8952 + 0.40 * 1.896

           = 7.89552% that is approximately equal to 7.90%

Note: 3 Calculation of cash flow after 8 years

Cash flow after 8 years = Cash flow of 8th year / WACC

         = 579010/ 0.079

         = $ 7,329,240