Question

Lava Lamps Inc. had $800 million in earnings before interest and taxes last year.

It has just acquired a 50% stake in General Lamps Inc., which had $400 million

in earnings before interest and taxes last year. Because Lava Lamps has a major-

ity active stake, it has been asked to consolidate last year’s income statements for

the two firms.

a. What earnings before interest and taxes would you see in the consolidated

statement?

b. If both firms have a 5% stable growth rate, a 10% cost of capital, a 40%

tax rate, and a return on capital of 11%, estimate the value of equity in

Lava Lamps.

c. How would your answer change if you were told that General Lamps has a

9% cost of capital and a 15% return on capital?

Answer 1

a. Earnings before interest and taxes in the consolidated income statement of Lava Lamps Inc.
	$ Millions
Earnings before interest & taxes	800
Add: 50% Share of EBIT of General Lamps Inc.(400*50%)	200
Add: Minority interests' 50% Share of EBIT of General Lamps Inc.(400*50%)	200
Total EBIT appearing in the consolidated income statement	1200
b.Value of Total Equity in Lava Lamps Inc.
Value of Equity=Next Yr. EAT/(Reqd. return-Growth rate)
ie.( Current EBIT*(1-Tax Rate)*(1+g))/(Reqd. return-g)
ie. (400*(1-40%)*(1+0.05))/(11%-5%)=
4200
c. Value of equity decreases as the reqd. return increases.
(400*(1-40%)*(1+0.05))/(15%-5%)=
2520