17.12 Kinedyne, Inc., has decided to divest one of its divisions. The assets of the group have the same operating risk characteristics as those of the parent firm. The capital structure for the parent has been stable at 40-percent debt/60-percent equity (in market-value terms), the level determined to be optimal given the firm’s assets. The required return on Kinedyne’s assets is 16 percent, and the firm (and the division) borrows at a rate of 10 percent.

Sales revenue for the division is expected to remain stable indefinitely at last year’s level of $19,740,000. Variable costs amount to 60 percent of sales. Annual depreciation of

$1.8 million is exactly matched each year by new investment in the division’s equipment.

The division would be taxed at the parent’s current rate of 40 percent.

a. How much is the division worth in unleveraged form?

b. If the division had the same capital structure as the parent firm, how much would it be worth?

c. At this optimal capital structure, what return will the equityholders of the division require?

d. Show that the market value of the equity of the division would be justified by the earnings to shareholders and the required return on equity.