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 $1.5 million per year, growing at a rate of 2.5% per year. Goodyear has an equity cost of capital of 8.5%, a debt cost of capital of 7%, a marginal corporate tax rate of 35%, 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

Answer 1

$47.77 million

Step-by-step explanation:

We can calculate levered value of the plant using Weighted Average Cost of Capital

rWACC = E/E+D*rE + D/E+D*rd(1-rc)

Equity cost of capital (rE) = 8.5%, Debt cost of capital (rc) = 7%, Marginal corporate tax rate (tc) = 35%, Debt equity ratio = 2.6

Goodyear's WACC = 1/1+2.6*8.5% + 2.6/1+2.6 * 7% *(1-35%)

= 0.0236 + 0.0328

= 0.0564

= 5.64%

The free cash flow of $1.5 million growing at a rate of 25% per year for the plant can be valued as a growing perpetuity.

Divestiture(Vl) calculation is as follows

Vl = Cash flow / rWACC - G

Vl = 1.5 million / 5.64% - 2.5%

Vl = 1.5 million / 3.14%

Vl = $47.77 million

So, Goodyear Tire and Rubber Company must receive $47.77 million for the divestiture to be profitable.