Weston Enterprises is an all-equity firm with two divisions. The soft drink divi

Question

Weston Enterprises is an all-equity firm with two divisions. The soft drink division has an asset beta of 0.65, expects to generate free cash flow of $72 million this year, and anticipates a 4% perpetual growth rate. The industrial chemicals division has an asset beta of 1.11, expects to generate free cash flow of $52 million this year, and anticipates a 3% perpetual growth rate. Suppose the risk-free rate is 2% and the market risk premium is 6%. Estimate the value of each division. Estimate Weston's current equity beta Estimate Weston's current cost of capital. Is this cost of capital useful for valuing Weston's projects? How is Weston's equity beta likely to change over time? Estimate the value of each division. The cost of capital for the soft drink division is | The value of the soft drink division is $ million. (Round to one decimal place.) The cost of capital for the industrial chemicals division is. (Round to two decimal places.) The value of the industrial chemicals division is $ million. (Round to one decimal place.) b. Estimate Weston's current equity beta. Weston's current equity beta is (Round to two decimal places.) Estimate Weston's current cost of capital. Is this cost of capital useful for valuing Weston's projects? How is Weston's equity beta likely to change over time? Weston's current cost of capital is (Round to two decimal places.)

Explanation / Answer

1) a. Cost of capital of Soft drink Division = Cost of Capital = Risk free rate + Beta x Market Risk Premium Cost of Capital = 2% + 0.65 x 6% 5.90% b. Value of Soft Drink division = Free cash Flow / (cost of capital - growth rate) Value of Soft Drink division = $72 million /(5.90% - 4%) $3,789.47 Million c. Cost of capital of Chemical Division = Cost of Capital = Risk free rate + Beta x Market Risk Premium Cost of Capital = 2% + 1.11 x 6% 8.66% d. Value of chemical division = Free cash Flow / (cost of capital - growth rate) Value of Soft Drink division = $52 million /(8.66% - 3%) $918.73 Million 2) Total value of firm = ($3,789.47+$918.73 ) Million $4,708.2 Million Current equity beta = Beta soft x Value Soft/Total value + Beta Chemical x Value Chemical/ Total Value Weston's Current equity beta = 0.65 x $3789.47/$4,708.2 + 1.11 x $918.73/$4,708.2 0.74 3) Weston's cost of Capital Cost of Capital = Risk free rate + Beta x Market Risk Premium Weston's Cost of Capital = 2% + .74 x 6% 6.44% Its not useful because individual divisions are either less risky or more risky. Weston’s equity beta will decline towards 0.65 as the soft drink division has a higher growth rate and will be representing a larger fraction of the firm

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