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

10% and it should go forward.

Step-by-step explanation:

So, from the question above we have the following parameters which is going to help in solving this particular Question/problem.

=> The current debt-to-equity ratio of AAA Inc. = 3.

=> The cost of equity of BBB Inc. = 14%.

=>The cost of debt of BBB Inc. = 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%. "

Therefore, the discount rate of AAA Inc = (0.5 × 14%) +0.5 × 7% × ( 1 - 25%) = 10%.

Also, the discount rate of BBB In. = =60 × 14% + 40 × 7% × ( 1 - 25% ) = 11%

The operation should go forward because the discount rate of BBB Inc is greater than thar of AAA inc.

10% and it should go forward.