Question

Suppose Luther Industries is considering divesting one of its product lines. The product line is expected to generate free cash flows of $2 million per year, growing at a rate of 3% per year. Luther has an equity cost of capital of 10%, a debt cost of capital of 7%, a marginal tax rate of 35%, and a debt-equity ratio of 2. This product line is of average risk and Luther plans to maintain a constant debt-equity ratio. The unlevered value of Luther's Product Line is closest to:

Answer 1

Answer:

$61,127,596

Explanation:

formula for the value of operations =

[Free Cash Flows (1 + growth rate)] / (WACC - growth rate)

where

We have D/E = 2 or D=2*E  (debt-equity ratio)

Tax = T=35%,

Ks=10%,

Kd =7%

Kd*(1-T) = 7%*(1-35%) = 4.55%

WACC = Kd*(1-T)*(D/(D+E)) + Ks*(E/(D+E))

WACC = 4.55%*(2E/3E) + 10%*(E/3E)

WACC = 4.55%*(2/3) + 10%*(1/3)

WACC = 6.37%

Value of Ops = 2000000*(1+3%)/(6.37%-3%)

Value of Ops = $61,127,596

to be profitable it must receive for the product line $61,127,596