Question

AAA Inc. has a current debt-to-equity ratio of 3, and is considering expanding its operations into a new industry. Firms in this new industry face a different set of risks than AAA Inc. However, the executives at AAA Inc. observe that a company in the new industry (BBB Inc.) has a cost of equity of 14%, a cost of debt of 7%, and a debt-to-value ratio of 40%. AAA Inc. plans to finance its expansion into the new industry with 50% debt and 50% equity. The cost of debt for AAA Inc. is also 7%, and the corporate tax rate is 25%. Solve for the discount rate that AAA Inc. should use when evaluating whether to go forward with the expansion.

Answer 1

Debt to value ratio of BBB =40%
Discount Rate =Weight of Equity*Cost of Equity +Weight of Debt*Cost of Debt*(1-Tax Rate) =
=60*14%+40*7%*(1-25%) =10.50%

Target Debt equity ratio =50/50 =1
Cost of Debt of AAA =7%
Cost of Equity =14% (As per industry)
Discount Rate of AAA inc =Weight of Equity*Cost of Equity +Weight of Debt*Cost of Debt*(1-Tax Rate) =
=0.5*14%+0.5*7%*(1-25%) =9.625%

Since discount rate for AAA is less than of BBB inc it should go ahead with the project.