Question

Topstone Industries has an expected EBIT of $1,000,000, a cost of equity of 10% and a cost of debt of 6%. Topstone s debt-to-equity ratio is 0.5. The corporate tax rate is 50%. What is the appropriate discount rate to be used under the APV method to value Topstone?"

A.
10.0%

B.
9.8%

C.
9.2%

D.
10.8%

E.
7.7%

Answer 1

Ans A) Appropriate Discount rate = 10% that is cost of equity

Explanation: Adjusted present value (APV) calculates the net present value assuming that the project is financed solely by equity and then we add the present value of financing benefits. In this method we use the cost of equity as the discount rate rather than WACC. Steps too calculate APV are as follows:

Step 1 : Calculate the value of a company with no leverage. This is done by calculating a NPV at the cost of equity as the discount rate.

Step 2 : Calculate the expected tax benefit from of debt. Expected tax benefits are discounted either at the cost of debt or at a higher rate to taken into account uncertainties about the tax effects.

Step 3: The NPV of the tax benefits is then added to the base NPV.

Step 4: Calculate Expected cost of bankruptcy.

Therefore, the appropriate discount rate to be used under the APV method to value Topstone is the cost of equity