Suppose Goodyear Tire and Rubber Company is considering divesting one of its man

Question

Suppose Goodyear Tire and Rubber Company is considering divesting one of its manufacturing plants. The plant is expected to generate free cash flows of $1.57 million per year, growing at a rate of

2.6% per year. Goodyear has an equity cost of capital of 8.5%, a debt cost of capital of

6.7%, a marginal corporate tax rate of 34%, and a debt-equity ratio of 2.6. If the plant has average risk and Goodyear plans to maintain a constant debt-equity ratio, what after-tax amount must it receive for the plant for the divestiture to be profitable?

Explanation / Answer

Debt Equity ratio = 2.60

Weight of debt = 72%

Weight of equity = 28%

Before tax cost of debt = 6.70%

Tax rate = 34%

After tax cost of debt = 6.70% × (1 - 34%)

= 4.42%

After tax cost of debt is 4.42%

Now, WACC is calculated below:

WACC = (72% × 4.42%) + (28% × 8.50%)

= 3.19% + 2.36%

= 5.55%

WACC of company is 5.55%.

Value of firm = $1.57 / (5.55% - 2.60%)

= $1.57 / 2.95%

= $53.13 million.

Value of firm is $53.13 million.

So, fter-tax amount must it receive for the plant for the divestiture to be profitable is $53.13 million.

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