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 $ 1.69 million per year, growing at a rate of 2.3 % per year. Goodyear has an equity cost of capital of 8.7 %, a debt cost of capital of 6.9 %, a marginal corporate tax rate of 33 %, and a debt-equity ratio of 2.7. 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

WACC = we x ke + wd x kd x (1 - tax)

here, we - weight of equity = 1 - wd, ke - cost of equity = 8.7%, wd - weight of debt, kd - cost of debt = 6.9%

wd = D/E / (1 + D/E) = 2.7 / (1 + 2.7) = 73%, we = 1 - 73% = 27%

=> WACC = 27% x 8.7% x (1 - 33%) + 73% x 6.9% = 6.61%

Value of firm = FCF / (WACC - g) = 1.69 / (6.61% - 2.3%) = $39.21 million is the amount that Goodyear must receive in order for the divestiture to be profitable.

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