Financial Evaluation of a Divestiture

A divestiture involves the sale of a division or plant or unit of one firm to another. From the seller’s perspective, it is a form of contraction; from the buyer’s point of view it represents expansion. Hence a divestiture is the obverse of a purchase. It is important to recognize that companies often achieve external expansion by acquiring an operating unit – plant, division, product line, subsidiary, etc – of another company. In such a case the seller generally believes that the value of the firm will be enhanced by converting the unit into cash or some other more productive asset. The selling of some of a firm’s assets is called divestiture. Unlike business failure, the motive for divestiture is often positive; to generate cash for expansion of other product lines, to get rid of a poorly performing operation, to streamline the corporation, or restructure the corporation’s business consistent with its strategic goals.

Financial Evaluation of a Divestiture

Typically, when a firm sells a division (or plant) to another company, it transfers the assets of the division along with the liabilities of the division, with the concurrence of the creditors. This means that the selling firm (referred to hereafter as the parent firm), in essence, transfers its ownership position in that division. To assess whether it is worth doing so from the financial point of view, the following procedure may be followed:

  • Step 1: Estimate the divisional post-tax cash flow: The parent firm should estimate the post-tax cash flow relating to the operations of the division and the rest of the operations of the parent firm. The relevant issue in this context is: What happens to the post-tax cash flow of the parent company with the division and without the division? The difference between the two represents the post-tax cash flow attributable to the division.
  • Step 2: Establishment the discount rate for the division. The discount rate applicable to the post-tax cash flow of the division should reflect its risk as a stand-alone business. A suggested procedure is to look at the cost of capital of some firm (or a group of firms) engaged solely or substantially in the same line of business and that is about the same size and use it as proxy for the division’s cost of capital.
  • Step 3: Calculate the division’s present value: Using the discount rate determined in Step 2 calculates the present value of the post-tax of the post-tax cash flow developed in Step 1. This represents the current worth of the cash flow generating capability of the division.
  • Step 4: Find the market value of the division-specific liabilities: The market value of the division specific liabilities is simply the present value of the obligations arising from the liabilities of the division. Remember that the market value of the division specific liabilities will be different from the book value of the division-specific liabilities if the contracted interest rates on these liabilities are different from the current interest rates.
  • Step 5: Deduce the value of the parent firm’s ownership position in the division. The value of the ownership positive (VOP) enjoyed by the parent firm in the division is simply calculated by Cash flow subracted by Liabilities
  • Step 6: Compare the value of ownership position (VOP) with the divestiture proceeds (DP). When a parent firm transfers the assets of a division along with its liabilities, it receives divestiture proceeds (DP) as compensation for giving up its ownership position in the division. So, the decision rule for divestiture would be as follows:
    1. DP > VOP Sell the division
    2. DP = VOP Be indifferent
    3. DP < VOP Retain the division

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