You were recently appointed the CEO of a firm with two divisions. Division 1 pro

Question

You were recently appointed the CEO of a firm with two divisions. Division 1 produces regular telephones. Division 2 produces specialty micro-chips which are used in cell phones. The market value of your firm's debt is $100 million and the market value of your firm's equity is also $100 million. The overall value of your firm is thus $200 million. The beta of your firms' equity is currently 2 and your firm's debt is riskless. Your firm holds excess cash of $40 million. The expected excess return on the market over the riskless rate is 8 percent and the risk- free rate is 2 percent. Assume that the CAPM holds and debt and equity are correctly priced. a) Calculate the (operation) asset beta for your firm. Is your answer lower or higher than the equity beta, 2? Interpret your answer. Suppose that you cannot identify a firm that is comparable in systematic risk to your cell phone division (Division 2), but do manage to identify a single-segment telephone firm, firm X, whose underlying business has systematic risk (beta) identical to that of your telephone business (Division 1). Firm X has an equity beta of 1.0, a debt beta of 0.1, and a debt-to-equity ratio of 0.5. Firm X does not hold any excess cash. Furthermore, you expect cash flows from Division 1 to be $5 million per year indefinitely (from t=1 onward). b) What is the value of Division 1? c) What is the value of Division 2? Engineers in Division 2 now discover an opportunity to invest in a new production technology which would enable it to produce better micro-chips. The required investment would be $15 million today (t=0), but the investment would increase expected Division 2 cash flows by $4 million per year (each year, indefinitely, starting at t=1). You should assume that the systematic risk (the asset beta) of Division 2 will be unaffected by the switch to the new production technology. d) What is the beta for Division 2? Would you recommend that your firm invest in the new production technology? [Hints for Question 3] b) Start by working out the asset beta of Division 1 c) Total Value of Your Firm = Value of Division 1 + Value of Division 2 + Excess Cash d) Beta of a portfolio is weighted average of individual betas. You already have the beta of (total) operation asset and the beta of Division 1.

Explanation / Answer

if the beta value is 2, it indcates that the risk is much higher and if the market return is 1, then the stock return is 2 and vice versa.

if the firm equity value is $100 million and if its beta is 2, then the total value of the firm will be $200 million and the total value of the firm will be $300 millions

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