Question

Feasibility of a Divestiture Merton, Inc., has a subsidiary in Bulgaria that it fully finances with its own equity. Last week, a firm offered to buy the subsidiary from Merton for $60 million in cash, and the offer is still available this week as well. The annualized long-term risk-free rate in the United States increased from 7 to 8 percent this week. The expected monthly cash flows to be generated by the subsidiary have not changed since last week. The risk premium that Merton applies to its projects in Bulgaria was reduced from 11.3 to 10.9 percent this week. The annualized long-term risk-free rate in Bulgaria declined from 23 to 21 percent this week. Would the NPV to Merton, Inc., from divesting this unit be more or less than the NPV determined last week? Why? (No analysis is necessary, but make sure that your explanation is very clear.)

Answer 1

NPV to Merton, Inc., from divesting this unit would be more than the NPV determined last week.

Although the expected monthly cash flows to be generated by the subsidiary have not changed since last week, NPV would be higher since:

1.  The annualized long-term risk-free rate in the United States increased by 1% from 7 to 8 percent this week

2. The risk premium that Merton applies to its projects in Bulgaria was reduced by 0.4% from 11.3 to 10.9 percent this week.

The increase of 1% in risk free rate would be partly offset by decrease of 0.4% in risk premium. But there will still be (1% - 0.4%=) 0.6% net increase in required rate of return.

An increase in required rate of return would result in higher NPV from divesting this unit with the buy offer $60 million in cash, as compared to the NPV determined last week.