Problem #3 (10 marks)

Komfort Design Company (Komfort) is considering entering the fashion industry with a new line of purses made from recycled plastic. Your job is to determine if Komfort should enter this new line of business. The new division of Komfort would have a higher level of risk than the parent company due to the competitiveness of this market.

You have been given the following information on the parent company (Komfort), its new division, and the market:

• Komfort: = 0.5, D/E = 0.60, tax rate = 30%, R_D = 7%
• Market information: Return on Government of Canada 3-month T-bills = 5%, Market risk premium is 5%

Komfort has identified a pure play company, Plastic Purses Inc (PPI), to use in its analysis of the new division.

• PPI: = 1, W_D = 40%, W_E = 60%, tax rate = 40%, R_D = 9%

Determine the appropriate discount rate that Komfort 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 the parent company, Komfort.