1. Firm XYZ has two lines of business, organized as two divisions, A and B. Division A generates a risk-free cash flow. It will produce $3 million in free cash flow next year and it will grow at 2% each year there after forever. The second line of business, run by Division B, is risky. It expects to generate a cash flow of $2 million next year and will grow at a rate of 4%. Currently, the total market value of XYZ is $120 million. The risk-free interest rate is 5%.

1. What is the cost of capital for the second line of business?
2. Assume the company comesacross a new technology that can improvethe Division B’s profitability. It requires an initial investment of $5 million and will increase next year’s cash flow by $1.1 million as well as future cash flows so that their growth rate stays at 4%. If the management decides to take on this new technology, what will the marketvalue of XYZ now be?

Answer rating: 100% (QA)

SOLUTION To calculate the cost of capital for Division B we can use the capital asset pricing model ... View the full answer