# Question

A diversified company plans to sell a division as part of a restructuring program. The division to be sold is a regional airline that was acquired by a previous management. The finance department has been asked by the chief executive officer (CEO) to estimate what they consider an acceptable price before entering into discussion with their investment bankers. The chief financial officer (CFO) intends to value the division on the basis of the present value of its future cash flows. He agrees with the CEO on the major assumptions that will affect the cash flows.

But they disagree on the appropriate discount rate. The CEO believes that they should use the company’s weighted average cost of capital (WACC), which at present is 6.4 percent and calculated as follows:

• Debt-to-equity ratio (D/E) = 0.5; cost of debt (kD) = 6 percent; risk-free rate (RF) = 5 percent; corporate tax rate = 30 percent; market risk premium = 5 percent; company beta = 0.5

• Cost of equity kE:

kE = RF + (RM − RF) × b

where RF = 5 percent is the risk-free rate, (RM − RF) = 5 percent is the market risk premium, and b = 0.5 is the company’s beta coefficient. Thus,

kE = 5% + 5% × 0.50 = 7.50%

The CFO disagrees, arguing that the airline is a completely different type of business and that it carries much more debt than the other divisions because of very large equipment purchases. Therefore, the corporate WACC is completely inappropriate for valuing the cash flows of the airline division. They should base the valuation on a cost of capital typical for the airline industry. To do this, the

CFO obtains the following data for a sample of pure-play airline companies.

a. The cost of borrowing and the debt-to-equity ratio for the division were to be set at the average for the group of airlines shown in the table. Based on the comparative data shown in the table, a risk-free rate of 5 percent, a market risk premium of 5 percent, and a tax rate of 30 percent, estimate the division’s WACC.

b. If the company’s WACC had been used instead of the divisional WACC you have just computed, what effect would that have on the valuation?

But they disagree on the appropriate discount rate. The CEO believes that they should use the company’s weighted average cost of capital (WACC), which at present is 6.4 percent and calculated as follows:

• Debt-to-equity ratio (D/E) = 0.5; cost of debt (kD) = 6 percent; risk-free rate (RF) = 5 percent; corporate tax rate = 30 percent; market risk premium = 5 percent; company beta = 0.5

• Cost of equity kE:

kE = RF + (RM − RF) × b

where RF = 5 percent is the risk-free rate, (RM − RF) = 5 percent is the market risk premium, and b = 0.5 is the company’s beta coefficient. Thus,

kE = 5% + 5% × 0.50 = 7.50%

The CFO disagrees, arguing that the airline is a completely different type of business and that it carries much more debt than the other divisions because of very large equipment purchases. Therefore, the corporate WACC is completely inappropriate for valuing the cash flows of the airline division. They should base the valuation on a cost of capital typical for the airline industry. To do this, the

CFO obtains the following data for a sample of pure-play airline companies.

a. The cost of borrowing and the debt-to-equity ratio for the division were to be set at the average for the group of airlines shown in the table. Based on the comparative data shown in the table, a risk-free rate of 5 percent, a market risk premium of 5 percent, and a tax rate of 30 percent, estimate the division’s WACC.

b. If the company’s WACC had been used instead of the divisional WACC you have just computed, what effect would that have on the valuation?

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