The Aardvark Corporation is considering launching a new product and is trying to

Question

The Aardvark Corporation is considering launching a new product and is trying to determine an appropriate discount rate for evaluating this new product. Aardvark has identified the following information for three single division firms that offer products similar to the one Aardvark is interested in launching:

Comparable Firm

Equity Cost of Capital

Debt Cost of Capital

Debt-to-Value Ratio

Anteater Enterprises

12.50%

6.50%

50%

Armadillo Industries

13%

6.10%

40%

Antelope Inc.

14%

7.10%

60%

Required: Based upon the three comparable firms, calculate the most appropriate unlevered cost of capital for Aardvark to use on this new product.

Comparable Firm

Equity Cost of Capital

Debt Cost of Capital

Debt-to-Value Ratio

Anteater Enterprises

12.50%

6.50%

50%

Armadillo Industries

13%

6.10%

40%

Antelope Inc.

14%

7.10%

60%

Explanation / Answer

Unlevered cost of capital = Ku

Cost of equity = Ke

Cost of debt = Kd

Thus,

Ku = Ke*(E/(E+D)) + Kd*(D/(E+D))

Since, E+D = V (Value)

Ku = Ke*(E/V) + Kd*(D/V)

For Anteater Enterprises

Ku = 12.5%*.5 + 6.5%*.5 = 9.5%

For Armadillo Industries

Ku = 13%*(1-40%) + 6.1%*40% = 10.24%

For Antelope Inc.

Ku = 14%*(1-60%) + 7.1%*60% = 9.86%

If Aardvark Corporation wants to be conservative, then the company should choose the highest unlevered cost of capital as the benchmark. Thus, company will choose 10.24% as the discount rate to evaluate the new product as mentioned in the problem.

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