Your firm has decided to spin off Android01 and Processor01 as a separate firm. The owners of the new firm will be equity holders and debt holders. After speaking with potential investors, investment banks have identified two possible capital structures (structure of equity and debt ownership):
- Debt holders receive debt that pays them coupons of $2 million a year, and $30 million after 20 years (these are expected values as the coupons and principal payments are not riskless, the debt buyers realize the firms could default). They price the debt using a discount rate of 4 percent. Equity holders receive expected dividends of $3 million starting from year 5, and growing at a rate of 4 percent per year (a growing perpetuity). They price the equity using a discount rate of 7.5 percent.
- Debt holders receive debt that pays them coupons of $1 million a year, and $12 million after 20 years (these are expected values as the coupons and principal payments are not riskless, the debt buyers realize the firms could default). They price the debt using a discount rate of 3.5 percent. Equity holders receive expected dividends of $3.9 million starting from year 5, and growing at a rate of 4.5 percent per year (a growing perpetuity). They price the equity using a discount rate of 7 percent.
Your firm receives all the proceeds from the sale debt and equity.
Prepare a Capital Budgeting and Cost of Capital report that answers the following Question.
Which particular capital structure should be chosen for the spin-off?