Question

Weston Enterprises is an​ all-equity firm with two divisions. The soft drink division has an asset beta of 0.64​, expects to generate free cash flow of $67 million this​ year, and anticipates a 3% perpetual growth rate. The industrial chemicals division has an asset beta of 1.07​, expects to generate free cash flow of $47 million this​ year, and anticipates a 2% perpetual growth rate. Suppose the​ risk-free rate is 2% and the market risk premium is 6%.

b. Estimate​ Weston's current equity beta

c. Estimate​ Weston's current cost of capital. Is this cost of capital useful for valuing​ Weston's projects? How is​ Weston's equity beta likely to change over​ time?

Answer 1

Answer :

First we will calculate value of soft drink division :

Ru = 2% + 0.64*6% ==> 5.84%

Value = Free cash flow / ( Ru - growth rate )

Value = 67 / (5.84% - 3%) ==> 2359.15

Then calculate value of chemical division :

Ru = 2% + 1.07*6% ==> 8.42%

Value = 47 / (8.42%-2%) ==> 732.09

Total = 2359.15 + 732.09 ==> 3091.24

(b) Now we will calculate equity beta :

= (2359.15/3091.24 * 0.64) + (732.09/3091.24 * 1.07)

= 0.488430532731 + 0.253405203090

= 0.74

(c) Current cost of capital = 2% + 0.74*6% ==> 6.44%

This cost of capital is Not useful! Individual divisions are either less risky or more risky.

Change over time : Weston’s equity beta will decline towards 0.64 as the soft drink division has higher growth rate, and so will represent a larger fraction of the firm.