Question
6. ABC, Inc. is considering acquiring a new division that makes complicated computer simulations for ECO classroom use. The new division will require an initial
6. ABC, Inc. is considering acquiring a new division that makes complicated computer\ simulations for ECO classroom use.\ The new division will require an initial investment of $500,000. If purchased, the new\ division will represent 20% of ABCs assets.\ The CFO of ABC has determined that the new division will have a 50% chance of\ generating an annual payoff of $120,000 forever, a 40% chance of an annual payoff of\ $75,000 forever and a 10% chance that the division will be a complete flop and generate\ no cash.\ Currently the firm has a debt/equity ratio of 40% and will maintain this capital structure for the\ new division. The current beta (equity beta) of the firm is 1.70. You notice that a publicly-\ traded competitor, XYZ, is in exactly the same line of business as the new division. You collect\ stock price data and determine that the beta of the equity of this competitor is 1.60. XYZ\ currently has a debt/equity ratio of .3. You also forecast that the market risk premium will be\ 6% and the Treasury bill rate will be 8%. Assume that both ABC and XYZ have risk-free debt\ paying the current market rate. Assume the tax rate of ABC and XYZ is 25%.\ a) What is ABCs required return on projects of the same risk as the overall company?\ Would you advise the managers of ABC to use this rate for the new division?\ b) What should be the required rate of return of the project? Should ABC buy the new\ division?\ c) What will happen to ABCs weighted average cost of capital if the new division is\ acquired?
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