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How much is the division worth in unlevered form

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Reference no: EM133113660

Grndhouse has decided to divest one of its divisions.

The assets of the division has the same operating risk characteristics as those of the parent firm. 40% of the total value of the division is debt-financed, and the dollar amount of debt that this corresponds to will be fixed in dollar terms going forwards. The expected return on Grndhouse's unlevered assets is 16%; in other words the firm's equity would have an expected rate of return of 16% if the firm were all-equity financed. Both the firm and the division borrow at a rate of 10%.

Earnings before interest and taxes for the division are expected to remain stable indefinitely at last year's level of £7,896,000. The division would be taxed at the parent's current rate of 40%. Ignore personal taxes.

  • How much is the division worth in unlevered form?
  • How much is the division worth in its levered form? How much of this belongs to the shareholders, and how much belongs to the bondholders?
  • At this capital structure, what is the expected return on the division's equity?
  • Show that the market value of the equity of the division would be justified by the earnings to shareholders and the expected return on the equity. In other words, show that the value of the equity in part (b) is also obtained by discounting the appropriate cash flows at the appropriate rate.

Reference no: EM133113660

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