In the face of disappointing earnings results and increasingly assertive institutional stockholders, Eastman Kodak considered a major restructuring in 1993. As part of this restructuring, it considered the sale of its health division, which earned $560 million in earnings before interest and taxes in 1993, on revenues of $5.285 billion. The growth in earnings was expected to diminish to 6% between 1994 and 1998 and to 4% thereafter. Capital expenditures in the health division amounted to $420 million in 1993, whereas depreciation was $350 million. Both were expected to grow 4% a year from 1994 onwards. Working capital requirements are negligible. The average beta of firms competing with Eastman Kodak’s health division is 1.15. Although Eastman Kodak has a debt ratio (D/(D+E)) of 50%, the health division can sustain a debt ratio (D/(D+E)) of only 20%, which is similar to the average debt ratio of firms competing in the health sector. At this level of debt, the health division can expect to pay 7.5% on its debt, before taxes. The tax rate is 40%, the Treasury bond rate is 7%, and market risk premium is 5.5%.

(a) Estimate the (after-tax) cost of capital (WACC) for the division.

(b) Estimate the value of the division as at the end of 1993.

(c) Why might an acquirer pay more than this estimated value?