7. As the result of stockholder pressure, RJR Nabisco is considering spinning of

Question

7. As the result of stockholder pressure, RJR Nabisco is considering spinning off its food division. You have been asked to estimate the beta for the division, and decide to do so by obtaining the beta of comparable publicly traded firms. The average beta of comparable publicly traded firms is 0.95, and the average debt/equity ratio of these firms is 35%. The division is expected to have a debt ratio of 25%. The marginal corporate tax rate is 36%. a. What is the beta for the division? b. Would it make any difference if you knew that RJR Nabisco had a much higher fixed cost structure than the comparable firms used here?

Explanation / Answer

We will first calculate the unlevered beta of the comparable firm from its levered beta of 0.95.

BetaU = BetaL / [ 1 + (1- tax rate) * D/E]

BetaU = 0.95 / [ 1 + (1-36%) * 35% ] = 0.84

Now we can use the unlevered Beta of 0.84 and adjust for the financing structure of RJR division to obtain the levered beta for RJR (using the above formula)

RJR Beta = 0.84 * [1 + (1-tax rate) * 25%] = 0.92

(b) A higher fixed costs would imply higher risk hence all things being equal the beta should be higher - the unlevered beta also called asset beta generally is expected to capture the average operating leverage and hence incorporates the cost structure risk however in this case since we are given that RJR has much higher fixed costs compared to comparable firm , it will mean that the unlevered beta calculated is strictly not comparable across the firms. Hence we should either look for another comparable firm which has similar fixed cost structure or we should look to adjust the above calculated beta upwards.

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