Question

Question 3 (Similar to Question 2, but capital structure is different) (12pt) 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. Its debt / value ratio is 10%. It will keep its debt /value ratio constant forever (even after spin-off). The online commerce division’s EBIT is expected to be 100 million at the end of this year and is expected to grow by 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. Fintech division’s current debt is 150 million and it will keep its debt/value ratio constant forever (even after spinoff). 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. The risk-free rate is 10%. The market Risk premium is 8%. The tax rate is 35%. (a) What is the cost of capital for SuperOnline’s fintech division? (3pt) (b) What is the fair value of SuperOnline’s fintech division’s equity? (3pt) (c) Compute the value and debt of the online commerce division of SuperOnline (3pt) (d) What is the cost of capital of SuperOnline’s online commerce division? (3pt)

Answer 1

3a). Fintech division should have the same cost of capital as Easy Fintech.

Cost of equity (using CAPM) = riskfree rate + beta*market risk premium

beta = (cost of equity - riskfree rate)/market risk premium = (15%-10%)/8% = 0.63 (levered beta)

Unlevered beta = levered beta/(1+(1-Tax rate)*D/E) = 0.63/(1+(1-35%)*25%) = 0.54

This should be the unlevered beta for Fintech division as well, so using SuperOnline's D/E ratio which is 10%/90% = 11.11%, levered beta for the Fintech division will be:

unlevered beta*(1 + (1-Tax rate)*D/E) = 0.54*(1+(1-35%)*11.11%) = 0.58

Cost of equity for Fintech division (using CAPM) = 10% + (0.58*8%) = 14.61%

Cost of debt = 10% (given as the riskfree rate)

So, using the capital structure ratio of SuperOnline,

cost of capital for the Fintech division = (debt ratio*cost of debt*(1-Tax rate)) + (equity ratio*cost of equity)

= (10%*10%*(1-35%)) + (90%*14.61%) = 13.80%

b). Value of Fintech operations (Vo) = EBIT*(1-Tax rate)/(WACC - growth rate) = 50*(1-35%)/(13.80%-7%) = 477.90 million

So, equity value of Fintech division = Vo - debt value = 477.90 - 150 = 327.90 million

c). Value of operations for SuperOnline = equity value/equity ratio = (price per share*number of shares)/(E/V ratio)

= (10*170)/90% = 1,888.89 million

Value of commerce division = value of SuperOnline - value of Fintech division

= 1,888.89 - 477.90 = 1,410.99 million

Again, debt of SuperOnline = Value of operations - equity value = 1,888.89 - 1,700 = 188.89 million

So, debt value of commerce division = debt of SuperOnline - debt of Fintech division

= 188.89 - 150 = 38.89 million

d). Value of operations of commerce division = EBIT*(1-35%)/(WACC - 2%)

WACC = (EBIT*(1-35%)/1,410.99) +2% = (100*(1-35%)/1,410.99) + 2% = 6.61% (cost of capital of commerce division)