Question

In: Finance

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 2 years ago
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