Suppose Luther Industries Is Considering Divesting One of Its Product

question 93

Essay

Suppose Luther Industries is considering divesting one of its product lines.The product line is expected to generate free cash flows of $2 million per year,growing at a rate of 3% per year.Luther has an equity cost of capital of 10%,a debt cost of capital of 7%,a marginal tax rate of 35%,and a debt-equity ratio of 2.If this product line is of average risk and Luther plans to maintain a constant debt-equity ratio,what after- tax amount must it receive for the product line in order for the divestiture to be profitable?

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Definitions:

Total Fixed Costs

Expenses that do not change with the level of output or sales, such as rent, salaries, and insurance premiums.

Area Under

Refers to the space beneath the curve of a graph in mathematics and statistics, often used to calculate integrals.

Average Cost

The total cost of production divided by the total quantity produced, indicating the cost per unit of output.

Marginal Costs

The additional cost incurred by producing one more unit of a good or service.