Auto Inc. an automobile manufacturer with a current debt-to-equity ratio of 2, is considering expanding operations. Unsurprisingly, the bicycle industry faces a different set of risks than the automobile industry. However, executives at Auto Inc. observe that Bike In., a bicycle company, has a cost of equity of 16% and cost of debt of 6%, and a debt-to-value ratio of 60%. Auto Inc. plans to finance expansion into bicycle production with 20% debt and 80% equity. The cost of debt at Auto Inc. is also 6%. The corporate tax rate is 25%. Solve the discount rate that auto Inc. should use when evaluating whether to go forward with expansion.

(Note: Auto Inc. does not want to use the adjusted present value method)

a. 10.4%

b 9.7%

c. 7.2%

d. 6.3%

e. 8.6%

(Provide steps)

 

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