You were recently appointed the CFO of a firm with two divisions. Division 1 produces regular telephones. Division 2 produces specialty micro-chips which are used in cell phones. The market value of your firm’s debt is $100 million and the market value of your firm’s equity is also $100 million. The overall value of your firm is thus $200 million. The beta of your firms’ equity is currently 2 and your firm’s debt is riskless. The expected excess return on the market over the riskless rate is 8 percent and the risk-free rate is 2 percent. Assume that the CAPM holds.
a) Calculate the asset beta for your firm.
Suppose that you cannot identify a firm that is comparable in systematic risk to your cell phone division (Division 2), but do manage to identify a single-segment telephone firm, firm X, whose underlying business has systematic risk (asset beta) identical to that of your telephone business (Division 1). This firm has an equity beta of 1.0, a debt beta of 0.1, and a debt-to-equity ratio of 0.5. Furthermore, you expect total cash flow (to the asset) from Division 1 to be $10 million per year indefinitely (from t=1 onward).
b) What is the value of Division 1? What is the value of Division 2? (Hint: Start by working out the asset beta of Division 1)
Engineers in Division 2 now discover an opportunity to invest in a new production technology which would enable it to produce better micro-chips. The required investment would be $15 million today (t=0), but the investment would increase expected Division 2 sales revenues by $4 million per year (each year, indefinitely, starting at t=1). You should assume that the systematic risk (the asset beta) of Division 2 will be unaffected by the switch to the new production technology.
c) What is the asset beta for Division 2? Would you recommend that your firm invests in the new production technology?
d) Suppose your firm announces at t=0 that it will invest in the new production technology and issues $15 million worth of debt to finance the upfront investment. If there are 10 million shares outstanding, what will the price per share be right after this has been done (i.e. right after t=0)?