Case 16: We Are Not All Alike!

1. This presentation will probably involve audience discussion, which will create action items. Use PowerPoint to keep track of these action items during your presentation • In Slide Show, click on the right mouse button • Select “Meeting Minder” • Select the “Action Items” tab • Type in action items as they come up • Click OK to dismiss this box • This will automatically create an Action Item slide at the end of your presentation with your points entered. Case 16:We Are Not All Alike! Case Discussion

2. Objectives • Calculate divisional costs of capital. • Compare a firm’s weighted average cost of capital with it’s divisional hurdle rates. • Evaluate proposals using the appropriate hurdle rate.

3. Background • Sandra Anderson, Finance VP at American Modular Systems, Inc. has to evaluate funding proposals from three divisions; Defense, Consumer Products, and Industrial Supply. • The firm currently has no clear policy regarding use of hurdle rate in evaluating capital budgeting proposals. • Sandra estimates that the overall hurdle rate is 14%, but that the various divisions are not equally risky. • She decides that she had better figure out a logical method of arriving at the divisional hurdle rates.

4. Question 1 • Using the data given in Table 2, determine the relative variability of each division’s sales as compared to that of the consolidated firm. • Which one is the riskiest and why?

5. Answer 1 The calculations show that the defense products division is the riskiest of the three. It’s sales are about 10% riskier than the consolidated sales of the firm. This is shown by the coefficient of variation of its sales relative to that of the consolidated sales figures.

6. Question 2 • Explain the process by which Sarah must have determined the hurdle rate for the entire company. • The corporate tax rate was 40%, the yield on outstanding bonds was 10%, treasury bills were yielding 6% and the market risk premium was estimated at 9%. • The company currently had 40% of its capital in the form of debt and the remaining in the form of common stock.

7. Answer 2 • Hurdle rate = Weighted average cost of capital (WACC) • WACC = Weight of debt*After-tax cost of debt + Weight of equity*Cost of equity • Where After-tax cost of debt = Yield to maturity *(1-Tax rate) = 10%(1-.4) =6% • And Cost of equity = Risk-free rate + (Market Risk premium)Beta • = 6%+ 9%(1.5) = 19.5% WACC = 0.4 * 6% + 0.6 * 19.5% = 2.4% + 11.7% = 14.1%

8. Question 3 • What is meant by the ‘pure play’ approach to estimating the required return on an investment?

9. Answer 3 • A company that focuses on a single line of business is called a “pure play” company • Thus when firms have multiple divisions, one way of trying to estimate the divisional costs of capital is to find companies that focus as exclusively as possible on the type of business that the division is involved in (pure play companies) and…. • use its required rate of return.

10. Question 4 • Using Sarah’s methodology of adjusting the firm’s hurdle rate based on the relative variability of each division’s sales in relation to that of the consolidated firm, calculate the divisional hurdle rates.

11. Answer 4 Where WACC (defense products) = 1.10*14.1%= 15.51%

12. Question 5 • Comment on this methodology of estimating the divisional hurdle rates. • Do you agree with it or not? • Explain your answer.

13. Answer 5 • In the absence of pure play firms, this methodology of estimating the divisional hurdle rate is quite logical. • The required rate of return (cost of capital) should reflect the relative riskiness or volatility of the firm and.. • the coefficient of variation is a good measure of risk per unit of return.

14. Question 6 • Using the firm’s overall weighted average cost of capital evaluate the three divisions’ project proposals. • What are your findings?

15. Answer 6 At the firm’s overall weighted cost of capital of 14.1%, only the defense products division’s proposal is acceptable since it has a positive NPV and an IRR of 14.17%. See spreadsheet solution (click here)

16. Question 7 • How do the decisions get affected when the divisional hurdle rates are used instead?

17. Answer 7 • When the divisional hurdle rates are used, Consumer Products division’s proposal has the highest NPV followed by… • the Industrial Products division. • The Defense Products division’s proposal would be rejected due to its negative NPV.