In: Finance
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 isWeston'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 isWeston'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.
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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