Question

Orange Inc., an orange juice producer with a current debt-to-equity ratio of 2, is considering expanding its operations to produce toothpaste. Unsurprisingly, the toothpaste industry faces a different set of risks than the orange juice industry. However, the executives at Orange Inc. observe that Paste Inc., a toothpaste company, has a cost of equity of 12%, a cost of debt of 6%, and a debt-to-value ratio of 40%. Orange Inc. plans to finance its expansion into toothpaste production with 50% debt and 50% equity. The cost of debt for Orange Inc. is also 6%, and the corporate tax rate is 25%. Solve for the discount rate that Orange Inc. should use when evaluating whether to go forward with the expansion Note: Orange Inc. does not want to use the Adjusted Present Value method.

Appropriate Rate = 12.08%
Appropriate Rate = 9.60%
Appropriate Rate = 13.20%
Appropriate Rate = 8.85%
Assume Last Inc. has no cash on hand, but wants to take on a project that adds $30 million in market value to the firm's assets, and has an NPV of $20 million. The project requires an initial investment of $10 million. LastQ Inc. wants to maintain its 50% Debt to Value Ratio.
How much debt should LastQ issue, and how much should they pay stockholders in dividends?
Issue $30 million in debt, pay $5 million to shareholders
Issue $15 million in debt, pay $5 million to shareholders Issue $10 million in debt, pay $20 million to shareholders
Issue $20 million in debt, pay $8 million to shareholders

Answer 1

Appropriate Rate = 8.85%

Step-by-step explanation:

Given the following :

Paste Inc,

cost of debt (Kd) = 6% = 0.06

Cost of Equity Ke = 12% = 0.12

Weight of debt ; Wd = 40%

Weight of equity; We = 1 - 40% = 0.6

Pretax discount :

We * Ke + Wd * Kd

0.6 * 0.12 + 0.4 * 0.06 = 0.096

For orange :

Weight of debt (Wd) = 50% = 0.5

Weight of Equity (We) = 50% = 0.5

Cost of debt (Kd) = 6% = 0.06

Tax rate (r) = 25% = 0.25

Cost of Equity (Ke) :

Pretax discount + 1(pretax discount - cost of debt)

0.096 + 1(0.096 - 0.06)

0.096 + 0.096 - 0.06 = 0.132

WACC: for orange Inc.

We * Ke + Wd * Kd * ( 1 - tax rate)

0.5 * 0.132 + 0.5 * 0.06 * (1 - 0.25)

0.5 * 0.132 + 0.5 * 0.06 * 0.75

0.066 + 0.0225

= 0.0885

= 0.0885 * 100%

= 8.85%