You have been hired as a consultant to help Ortiz Orthotics Corporation (OOC) determine if they should enter a new line of business. The new division would manufacture and sell compression arthritis gloves made from recycled material, which has a much higher risk level than the parent company as it is a very competitive market. You have been given the following information on the parent company (OCC), its new division, and the market:

•      OOC: β = 0.5, D/E = 0.75, tax rate = 30%, R_D = 7%

•      Market information: Return on Government of Canada 3- month T-bill = 5%, Expected return on the TSX = 10%

OOC has identified a pure play company (Glove Co) to use in its analysis of the new division.

•      Glove Co: β = 1, W_D = 40%, W_E = 60%, tax rate = 40%, R_D = 9%

 

Determine the appropriate discount rate that OOC should use when evaluating projects for its new division. The new division will have the same capital structure, tax rate and cost of debt as OOC.

Answer rating: 100% (QA)

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