The Board for Colton Industries is considering a proposal by the CEO to sell the
ID: 2705303 • Letter: T
Question
The Board for Colton Industries is considering a proposal by the CEO to sell the firm's boat manufacturing division. An anonymous buyer has offered through a business broker to purchase the boat division from Colton for $45 million. Since the book value of the boat division is also $45 million, there would be no taxes on the sale. Boat sales in the upcoming fiscal year are expected to be $60 million. However, yearly sales have been declining steadily at a rate of 3% per year. The CFO believes that the trend in boat sales cannot be reversed, and that sales in the boat division will continue to decline in perpetuity at a rate of 3% per year due to relentless competition from foreign manufacturers located in Paraguay. As further evidence supporting the proposed sale, the CEO notes that Colton's profit margin on boat sales is only 20% of sales. The CFO has argued that selling the boat division is attractive because the proposed sale has an internal rate of return that is greater than the firm's opportunity cost of capital of 10%. Assuming Colton has a marginal tax rate of 40%,
a. determine the internal rate of return for the proposed sale.
b. explain whether the Board should approve the sale of the boat division.
Explanation / Answer
The cash flows of the proposed sale are
+45 million rightaway
profit of 20% of 60 million 1 year down,
post tax its 12,000,000 * 0.6 = 7,200,000
profit declines by 3% every year there after
Hence the value cash flows are decreasing
Let the internal rate of return be x
45,000,000 = 7,200,000 / ( 1 + x ) + 7,200,000 / ( 1 + x )^2 * ( 1.03 ) + ...
The value on RHS is ( 7200000 / ( 1 + x ) ) / ( 1 - 1/( ( 1 + x ) * 1.03 ) ) = 45,000,000
7200000 * 1.03 / ( ( 1.03 - 1/( 1 + x ) ) * ( 1 + x ) ) = 45000000
1.03 + 1.03x - 1 = ( 7200000*1.03 ) / 45000000 = 0.1648
1.03x = 0.1648 - 0.03
x = 0.13087
a) Hence IRR is 13.087%
b) as IRR is > 10% which is the opputunity cost of capital, the board should not approve the sale of the boat division.
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