In the face of disappointing earnings results and increas- ingly assertive institutional stockholders, Eastman Ko- dak...

In the face of disappointing earnings results and increas- ingly assertive institutional stockholders, Eastman Ko- dak was considering the sale of its health division, which earned $560 million in EBIT in the most recent year on revenues of $5.285 billion. The expected growth in earn- ings was expected to moderate to 6% for the next five years, and to 4% after that. Capital expenditures in the health division amounted to $420 million in the most re- cent year, whereas depreciation was $350 million. Both are expected to grow 4% a year in the long run. Working capital requirements are negligible.

The average beta of firms competing with Eastman Ko- dak’s health division is 1.15. Although Eastman Kodak has a debt ratio (D?[D + E]) of 50%, the health division can sustain a debt ratio (D?[D + E]) of only 20%, which is similar to the average debt ratio of firms competing in the health sector. At this level of debt, the health division can expect to pay 7.5% on its debt, before taxes. (The tax rate is 40%, market risk premium is 5.5%, and the Treasury bond rate is 7%.)

a) Estimate the cost of capital for the division.

b) Estimate the value of the division.

Solutions

Expert Solution

(a)	Cost of equity -
	As pe CAPM -
	Re =	RF +(Rm-Rf)X Beta
	Re =	7 + (5.5 x 1.15)
		13.325

	Cost of debt =	7.5 x (1-40%)
		4.5

	Source	Weight	Cost	Weight x cost
	Equity	0.8	13.325	10.66
	Debt	0.2	4.5	0.9
				11.56
	WACC =	11.56

(b)	Year		1	2	3	4	5
	EBIT		593.6	629.216	666.969	706.9871	749.4063
	Post tax EBIT (EBIT x (1-40%))		356.16	377.5296	400.1814	424.1923	449.6438
	Less: Capital expenditure		436.8	454.272	472.4429	491.3406	510.9942
	Add: Depreciation		364	378.56	393.7024	409.4505	425.8285
	Free cashflows		283.36	301.8176	321.4409	342.3022	364.4781
	PV factor @ 11.56%		0.896379	0.803495	0.720235	0.645604	0.578705
	PV of FCF		253.9978	242.5088	231.5131	220.9915	210.9254

	PV of cash flows from explicit forecast periof =						1159.937

	Horizon Value =		FCF6/(Re-g)

	FCF6 =	FCF5 x 1.04 =		379.0572
	Re =			0.1156
	G =			0.04

	Horizon value =		379.0572/(0.1156-0.04)
			5013.984

	PV of Horizon value =		5013.984/(1.1156^5)
			2901.619

	Value of division =		1159.937 + 2901.619
			4061.556

jeff jeffy answered 1 year ago

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