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:

WACC

The Weighted Average Cost of Capital is a metric that calculates a company's cost of capital, with each capital category being weighted proportionally.

Capital Budgeting

The process by which investors or managers decide which capital investment projects - like new machinery or expansion plans - to undertake, based on potential profitability and risk analysis.

Opportunity Cost

A cash flow that a firm must forego to accept a project. For example, if the project requires the use of a building that could otherwise be sold, the market value of the building is an opportunity cost of the project.

Overall WACC

A comprehensive measure of a company's cost of capital, incorporating the weighted costs of its equity and debt financing.