Question

SuperOnline is a company composed of two divisions: online commerce and fintech. It is planning to spin off its fintech division. Currently, SuperOnline has 10 million shares of stocks trading at $170. It is unlevered. Online commerce division’s EBIT is expected to be 100 million at the end of this year and grow 2% every year. Fintech division’s EBIT is expected to be 50 million at the end of this year and is expected to grow 7% every year. EasyFintech is SuperOnline’s fintech business rival and it is only in fintech business. EasyFintech’s debt/equity ratio is 25%, its cost of equity is 15%. Assume all debts are riskless. Risk-free rate is 10%. Market Risk premium is 8%. Tax rate is 35%.

(a) What is cost of capital for SuperOnline’s fintech division? (4pt)
(b) What is the fair value (t=0 value) of SuperOnline’s fintech division’s equity? (4pt) (c) What is cost of capital (equity) of SuperOnline’s onlince commerce division? (4pt)

Answer 1

Part a)

Easyfintech cost of equity = Risk-free rate+(Beta*Market risk premium)

15% = 10%+(Beta*8%)

Beta*8% = 15%-10% = 5%

Beta(Levered) = 5%/8% = 0.625

Beta (Unlevered) for superonline Fintech division = Beta(Levered)/[1+(1-tax rate)*debt equity ratio of Easyfintech] = 0.625/[1+(1-0.35)*0.25] = 0.625/[1+(0.65*0.25)] = 0.625/[1+0.1625] = 0.625/1.1625 = 0.5376

Cost of capital for superonline Fintech division (Ke) = Risk-free rate+(Beta unlevered*Market risk premium) = 10%+(0.5376*8%) = 10%+4.3% = 14.3%

Note: Since Easyfintech & Superonline Fintech division is in same business so beta will be considered as proxy beta. Due to Superonline Fintech division is unlevered capital structure, we converted proxy beta(levered) into unlevered.

Part b)

Fair value of SuperOnline’s fintech division’s equity = EBIT*(1-tax rate)*(1+growth rate)/(Ke-growth rate) = 50,000,000*(1-0.35)*(1+0.07)/(0.143-0.07) = 50,000,000*0.65*1.07/0.073 = 476,369,863

Part c)

Value of superonline company = Number of share outstanding*Market price = 10million shares*170 = 1700million

Value of superonline online commerce division (Vc) = Value of superonline company-Fair value of SuperOnline’s fintech division’s equity = 1700million - 476,369,863 = 1,223,630,137

Cost of capital = [EBIT*(1-tax rate)*(1+growth rate)/Vc] + growth rate = [100million*(1-0.35)*(1+0.02)/1,223,630,137]+0.02 = [100million*0.65*1,02)/1,223,630,137]+0.02 = [66.3million/1,223,630,137]+0.02 = 0.0542+0.02 = 0.0742 or 7.42%