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.