Problem 3: CORPORATE RESTRUCTURING, COST OF CAPITAL AND VALUATION (40 points) Modern Living Omnimedia (MLO) is...

Transcribed Image Text:

Problem 3: CORPORATE RESTRUCTURING, COST OF CAPITAL AND VALUATION (40 points) Modern Living Omnimedia (MLO) is a conglomerate firm consisting of a furniture division, a house wares merchandising division and a publishing division. The market value shares of the three divisions in the firm's operating assets are 0.50, 0.30 and 0.20, respectively. The firm currently has 50 million shares outstanding at a price of $30 per share. MLO also has $500 million debt outstanding. The firm has maintained this level of debt in the recent past and is expected to do so in the future. MLO expects to generate a constant after-tax Free Cash Flow of $137.75 million in the foreseeable future. As part of a strategic repositioning effort, the firm is looking to spin off its furniture division. The following table contains relevant financial data on MLO and on ABC Furniture, a close competitor in the furniture industry. ABC Furniture generated constant cash flows in the recent past and maintained a constant level of debt of $350 million, corresponding with a current market D/V-ratio of 0.50. MLO ABC Furniture Equity Beta Market Debt Ratio (BE) (current D/V) Year 1.15 1.85 2022 Sales 800 Cost of Goods Sold (excl. Dep.) 480 Other Cash Costs 135 25 Depreciation EBIT 160 0.25 0.50 Investments in fixed assets 95 Additional investments in NWC 15 825 495 140 25 165 Bond Rating A group of investors is looking to buy the furniture division, and has made the following cash flow projections for the division for the next 5 years (in $ millions): 2023 95 15 A BB 2024 875 525 150 25 175 Credit Spread 95 15 1.0% 2.5% 2025 950 570 165 25 190 Cost of debt (rd) 95 15 3.5% 5.0% 2026 1,000 600 175 25 200 95 15 After this period, the investors expect the cash flows to grow at a constant rate of 2.5% per year. After the purchase, the investors plans to maintain a constant (target) debt ratio of 30% in market value terms at all times. The estimated bond rating for this debt level would be BBB with a corresponding credit spread of 1.75%. You can assume a risk free interest rate of 2.5%, and a market risk premium of 5%. Furthermore, you can assume an effective (marginal) tax rate of 20% for all firms. Finally, you can assume that all cash flows will be realized at the end of each period. (i) (ii) (iii) Calculate MLO's current cost of capital. Show all your calculations. (6 points) Determine the relevant cash flows for the valuation of MLO's furniture division by the group of investors. (8 points) Calculate the business risk of the furniture division and determine the relevant cost of capital for the valuation of the furniture division by the group of investors. (8 points) Problem 3: CORPORATE RESTRUCTURING, COST OF CAPITAL AND VALUATION (40 points) Modern Living Omnimedia (MLO) is a conglomerate firm consisting of a furniture division, a house wares merchandising division and a publishing division. The market value shares of the three divisions in the firm's operating assets are 0.50, 0.30 and 0.20, respectively. The firm currently has 50 million shares outstanding at a price of $30 per share. MLO also has $500 million debt outstanding. The firm has maintained this level of debt in the recent past and is expected to do so in the future. MLO expects to generate a constant after-tax Free Cash Flow of $137.75 million in the foreseeable future. As part of a strategic repositioning effort, the firm is looking to spin off its furniture division. The following table contains relevant financial data on MLO and on ABC Furniture, a close competitor in the furniture industry. ABC Furniture generated constant cash flows in the recent past and maintained a constant level of debt of $350 million, corresponding with a current market D/V-ratio of 0.50. MLO ABC Furniture Equity Beta Market Debt Ratio (BE) (current D/V) Year 1.15 1.85 2022 Sales 800 Cost of Goods Sold (excl. Dep.) 480 Other Cash Costs 135 25 Depreciation EBIT 160 0.25 0.50 Investments in fixed assets 95 Additional investments in NWC 15 825 495 140 25 165 Bond Rating A group of investors is looking to buy the furniture division, and has made the following cash flow projections for the division for the next 5 years (in $ millions): 2023 95 15 A BB 2024 875 525 150 25 175 Credit Spread 95 15 1.0% 2.5% 2025 950 570 165 25 190 Cost of debt (rd) 95 15 3.5% 5.0% 2026 1,000 600 175 25 200 95 15 After this period, the investors expect the cash flows to grow at a constant rate of 2.5% per year. After the purchase, the investors plans to maintain a constant (target) debt ratio of 30% in market value terms at all times. The estimated bond rating for this debt level would be BBB with a corresponding credit spread of 1.75%. You can assume a risk free interest rate of 2.5%, and a market risk premium of 5%. Furthermore, you can assume an effective (marginal) tax rate of 20% for all firms. Finally, you can assume that all cash flows will be realized at the end of each period. (i) (ii) (iii) Calculate MLO's current cost of capital. Show all your calculations. (6 points) Determine the relevant cash flows for the valuation of MLO's furniture division by the group of investors. (8 points) Calculate the business risk of the furniture division and determine the relevant cost of capital for the valuation of the furniture division by the group of investors. (8 points)

Answer rating: 100% (QA)

Solution 1 Calculate MLOs current cost of capital Show all your calculations 6 points MLOs cost of e... View the full answer