Case scenario:
Comfort Shoe Company of England has decided to spin off its Tango Dance Shoe Division as a separate corporation in the United States. The assets of the Tango Dance Shoe Division have the same operating risk characteristics as those of Comfort. The capital structure of Comfort has been 40% debt and 60% equity in terms of market values and is considered by management to be optimal. The required return on Comfort's assets (if unlevered) is 16% per year, and the interest rate that the firm (and the division) must currently pay on their debt is 10% per year. Sale revenue for the tango Shoe Division is expected to remain indefinitely at last year's level of $10 million. Variable costs are 55% of sales. Annual depreciation is $1 million, which is exactly matched each year by new investments. The corporate tax rate is 40%.
1) How much is the tango Shoe Division worth in unlevered form?
2) If the Tango Shoe Division is spun off with $5 million in debt, how much would it be worth?
3) What rate of return will the shareholders of the Tango Shoe Division require?
4) Show that the market value of the equity of the new firm would be justified by the earnings to the shareholders.