FFM is a semi-conductor manufacturing firm with three divisions. These are SOC T
ID: 2811142 • Letter: F
Question
FFM is a semi-conductor manufacturing firm with three divisions. These are SOC Tools (SOC), which constitutes 40 percent of the assets of the firm, Digital Equipment (DE), which constitutes 25 percent of the assets and Foundry Equipment (FE), which constitutes the remaining 35 percent of the assets. The unlevered (asset) betas of the three divisions (defined as the beta of the division if it were independent and 100% equity financed) are A,SOC = 1.5, A,DE =0.7 and A,FE = 0.5. FFM’s debt-to-equity ratio, B/S, is 3/7 and the corporate tax rate, tc, is 34%. The expected return on the market portfolio, rm, is 13 %. FFM can borrow at the risk free interest rate, rf, of 4%.
1. What is the discount rate, rA, which FFM should use for assessing projects in the SOC Tools division, the Digital Equipment division and the Foundry Equipment division? 2. Calculate the expected return on the equity, rS, of FFM? 3. FFM is thinking of acquiring TTT Corporation, which has 40 percent of its assets in the SOC Tools’s industry and 60 percent in the Foundry Equipment’s industry. What is FFM’s opportunity cost of capital, rwacc, of the TTT division, if FFM acquires TTT’s assets? Assume that FFM’s capital structure stays the same after the acquisition.
Explanation / Answer
Given Unlevered betas, to calculate the levered betas using the unlevered betas, we use
levered beta = unlevered beta *(1+(1-t)*D/E)
where t = corporate tax rate
D/E = debt to equity ratio of the company
Using the above the formula the levered betas would be
BL, SOC = 1.92
BL, DE = 0.9
BL, FE = 0.64
The cost of equity can be caluclated by
Re = W*(rf + BL(rm-rf))
where W = % of assets
rf = risk free rate
BL = Levered Beta of the division
rm = return on market portfolio
using the above formula, the cost of equity of each division would be
Re, SOC = 8.53%
Re, DE = 3.02%
Re, FE = 3.42%
1.) The discount rate (Ra) for each division can be calculated using WACC = E/(D+E)*Re + D/(D+E)*Rd*(1-t)
Ra, SOC = 6.76
Ra, DE = 2.91
Ra, FE = 3.19
2.) expected return on equity for FFM Rs = Re, SOC + Re, DE + Re, DE
= 8.53% + 3.02% + 3.42% = 14.97%
3.) for TTT Corp
Re, SOC = 8.53%
Re, FE = 5.86%
Cost of equity = 14.39%
Rwacc = 10.87%
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