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 $68 million this​ year, and anticipates a 4% perpetual growth rate. The industrial chemicals division has an asset beta of 1.11​, expects to generate free cash flow of

$75 million this​ year, and anticipates a 3% perpetual growth rate. Suppose the​ risk-free rate is 4% and the market risk premium is 4%.

a. Estimate the value of each division.

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?

a. Estimate the value of each division.

The cost of capital for the soft drink division is _____%.  (Round to two decimal​ places.)

The value of the soft drink division is

​$____ million.  ​(Round to one decimal​ place.)

The cost of capital for the industrial chemicals division is _____%.  (Round to two decimal​ places.)

The value of the industrial chemicals division is

​$____ million. ​ (Round to one decimal​ place.)

b. Estimate​ Weston's current equity beta.

​Weston's current equity beta is ____​ (Round to two decimal​ places.)

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?

​Weston's current cost of capital is _____%. (Round to two decimal​ places.)

Is this cost of capital useful for valuing​ Weston's projects?  ​(Select the best choice​ below.)

A. Not​ useful! Individual divisions are always more risky than the​ firm's cost of capital.

B.Useful. Individual divisions are sometimes less risky and sometimes more risky than the​ firm's cost of capital.

C.Not​ useful! Individual divisions are sometimes less risky and sometimes more risky than the​ firm's cost of capital.

D.Useful. Individual divisions are always less risky than the​ firm's cost of capital.

How is​ Weston's equity beta likely to change over​ time?  ​(Select the best choice​ below.)

A.Over​ time, Weston's equity beta will rise toward 1.11​, as the soft drink division has a higher growth rate and so will represent a larger fraction of the firm.

B.Over​ time, Weston's equity beta will decline toward 0.64​, as the soft drink division has a higher growth rate and so will represent a larger fraction of the firm.

C.Over​ time, Weston's equity beta will decline toward 0.64​, as the soft drink division has a lower growth rate and so will represent a smaller fraction of the firm.

D.Over​ time, Weston's equity beta will rise toward 0.64​, as the soft drink division has a higher growth rate and so will represent a larger fraction of the firm.

Answer 1

a)	Cost of Capital of Soft Drink Division
	= Rf + β(Rm-Rf)
	Where,
	Rf = Risk Free Rate = 4%
	β = Beta of Soft Drink Division = 0.64
	(Rm-Rf) = Market Risk Premium = 4%
	So,
	Cost of Capital of Soft Drink Division
	= Rf + β(Rm-Rf)
	= 4% + 0.64*4%
	= 4% + 2.56%
	= 6.56%
	Value of Soft Drink Division
	= Free Cash Flow / (Cost of Capital - Perpetual Growth Rate)
	= $68 million / (6.56% - 4%)
	= $68 million / 2.56%
	= $2656.25 million
	Cost of Capital of Chemicals Division
	= Rf + β(Rm-Rf)
	Where,
	Rf = Risk Free Rate = 4%
	β = Beta of Chemicals Division = 1.11
	(Rm-Rf) = Market Risk Premium = 4%
	So,
	Cost of Capital of Chemicals Division
	= Rf + β(Rm-Rf)
	= 4% + 1.11*4%
	= 4% + 4.44%
	= 8.44%
	Value of Chemicals Division
	= Free Cash Flow / (Cost of Capital - Perpetual Growth Rate)
	= $75 million / (8.44% - 3%)
	= $75 million / 5.44%
	= $1378.68 million
	Total Value of Weston Enterprises
	= Value of Soft Drink Division + Value of Chemicals Division
	= $2656.25 million + $1378.68 million
	= $4034.93 million
b)	Weston's Current equity beta will be weighted average beta of
	its 2 divisions.
	Weston's Current Beta
	= Beta of Soft Drink Division*(Value of Soft Drink Division/Total Value)
	+ Beta of Chemicals Division*(Value of Chemicals Division/Total Value)
	= 0.64*($2656.25/$4034.93) + 1.11*($1378.68/4034.93)
	= 0.42 + 0.38
	= 0.80
c)	Weston's current cost of capital can be calculated using current
	equity beta.
	So,
	Weston's Current Cost of Capital
	= Rf + β(Rm-Rf)
	= 4% + 0.80*4%
	= 4% + 3.20%
	= 7.20%
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