Julie DeHaan was at it again! It seemed like she made waves wherever she went. A
ID: 2817937 • Letter: J
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Julie DeHaan was at it again! It seemed like she made waves wherever she went. At her previous job, which incidentally was also with a Fortune 500 company, Julie had successfully implemented a system of evaluating projects based on differential (risk-adjusted) hurdle rates. However, the change caused so much uproar and unpleasantness among divisional heads that Julie knew her days at the job were numbered. Eventually she quit and given her sound credentials had no trouble finding another job. At her current job as VP of finance for Built-Rite Products Inc., Julie had to evaluate proposals that came in for funding from the firm’s three product divisions: defense, consumer products, and industrial supply. During her very first month at the job, she was presented with three funding requests, one from each department (see Table 1 for project cost and cash flow projections). Being unclear as to what the policy was regarding the hurdle rate to be used in evaluating such projects, Julie decided to calculate the company’s weighted average cost of capital herself. After carefully analyzing the firm’s financial statements and talking to the underwriters, Julie estimated that the firm’s weighted average cost of capital was around 14%. When she consulted with her boss, Pete Rogers, she was pleased to learn that the firm had been using 14% recently as the hurdle rate for all project evaluations. What troubled her was the fact that, like her previous employer, these folks too were not using differential hurdle rates for the three different divisions. “Here we go again,” thought Julie. “I should have asked about this at the interview. Oh well! I guess it’s too late now. I’ve got to do what I’ve got to do!” Built-Rite Products Inc., based in Raleigh, North Carolina, employed 5,200 people at its various corporate and manufacturing facilities. Its three divisions were organized on the basis of the type of products manufactured and the clientele served. The defense division accounted for around 55% of the sales volume, while the other two divisions split the balance. The company manufactured and supplied high-quality storage units made from aluminum, plastic, and wood. During the past few years the defense division had done extremely well and was bringing in the majority of the firm’s profits. However, as is typical of most defense contractors, there had been significant volatility in its sales and earnings figures over the past eight years. The consumer products and industrial supply divisions had been far less volatile, but their profit margins had been lower. Overall, though, the firm was fairly well diversified, and its beta had been estimated at 1.1. Julie decided that she had better figure out a more logical method of adjusting the divisional hurdle rates, because she strongly believed that failure to do so would result in the firm making unwise capital budgeting decisions. Given her training and philosophy, there was no way she was going to allow projects to be evaluated without due consideration being given to their respective volatilities. “We are not all alike,” she said to her boss, Pete, “and we should not pretend to be. Don’t you agree?” To her good luck, Pete agreed. So Julie went to work. The first thing she did was refer back to her notes from graduate school (they do come in handy sometimes, you know) and remembered that there were two ways she could go about doing the adjustment for differences in risk across corporate divisions. One way was to measure or collect the equity betas of comparable homogeneous companies and substitute those in place of the firm’s overall beta when calculating the weighted average cost of capital. The other way was to simply adjust the firm’s weighted average cost of capital up or down based on the relative variability of each division’s sales and/or earnings. After doing some research on the Internet, Julie decided against the first option because most of the firm’s competitors were involved in multiple industry sectors. Accordingly, she decided to go ahead with the second alternative and requested the accounting department to provide her with quarterly sales data for the prior eight years broken down by divisions (Table 2). She calculated the relative variability of each division’s revenues with respect to that of the overall firm and accordingly adjusted the firm’s hurdle rate when evaluating proposals submitted by each department.
After doing some quick calculations, Julie sent emails to the vice presidents of the three divisions setting up a time for a meeting. Somehow, Julie knew that it was not going to be a pleasant meeting.
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?
2. Explain the process by which Julie must have determined the hurdle rate for the entire company. The corporate tax rate was 40%, the yield on outstanding bonds was 11%, treasury bills were yielding 4%, and the market risk premium was estimated at 10%. The company currently had 30% of its capital in the form of debt and the remaining in the form of common stock.
3. What is meant by the “pure play” approach to estimating the required return on an investment?
4. Using Julie’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.
5. Comment on this methodology of estimating the divisional hurdle rates. Do you agree with it or not? Explain your answer.
6. Using the firm’s overall weighted average cost of capital, evaluate the three divisions’ project proposals. What are your findings?
Projected Costs,Lives, and Cash Inflaws af Divisional Proposals Cost $1,400,000 $1,600,000 $1,800,000 Annual net Cash Flow $400,000 $390,000 $396,000 Divisional Breakdown of Quarterly Revenues se Consumer Products Quarterly Revenues rial Supp Defense Products Consumer Products Industrial Products Consolidated 1,620,000 $6,145,000 $1,668,600 $6,385,350 $1,718,658 $6,635,711 $1,770,218 $6,896,522 $1,823,324 $7,168,245 $1,878,024$7,451,360 $1,934,365 $7,674,901 1,992,396$7,905,148 $2,052,168 $8,142,303 $2,113,733 $8,386,572 $2,177,145 $8,638,169 $2,242,459 58,897,313 $2,309,733 $9,164,234 S2,379,025 $9,439,161 $2,450,395 9,722,334 2,523,907 $9,640,987 $2,599,624 $10,063,104 $2,677,613 $10,411,951 $2,757,942 $10,773,142 $2,840,680 $11,147,121 S2,925,900 $11,534,351 3,013,677 $11,935,310 $3,104,088 $12,350,496 $3,197,210 $12,780,422 $3,325,099 $13,319,383 3,424,852 $13,848,719 3,527,597 $14,400,422 S3,668,701 $15,010,765 3,778,762 $15,611,294 $3,892,125 $16,237,350 $4,008,889 $16,890,074 $4,125,000 $17,825,000 $2,800,000 $2,940,000 $3,087,000 $1,725,000 $1,776,750 $1,830,053 $1,884,954 $1,941,503 $1,999,748 2,059,740 $2,121,532 $2,185,178 $2,250,734 $2,318,256 $2,387,803 52,459,438 2,533,221 $2,609,217 $2,687,494 S2,768,119 $2,851,162 $2,936,697 3,024,798 $3,115,542 $3,209,008 $3,305,278 $3,404,437 $3,506,570 $3,611,767 $3,720,120 $3,831,724 $3,946,675 $4,065,075 $4,187,028 $4,300,000 $3,403,418 $3,680,796 3,791,220 S3,904,957 $4,022,105 $4,142,768 $4,267,051 $4,395,063 $4,526,915 4,662,722 $4,429,586 $4,695,361 $4,883,176 $5,078,503 $5,281,643 $5,492,909 $5,712,625 $6,487,714 $7,152,705 $7,510,340 $8,280,150 $8,694,157 $9,400,000Explanation / Answer
1… Quarter Defense Products Consumer Products Industrial Products Consolidated 1 2800000 1725000 1620000 6145000 2 2940000 1776750 1668600 6385350 3 3087000 1830053 1718658 6635711 4 3241350 1884954 1770218 6896522 5 3403418 1941503 1823324 7168245 6 3573588 1999748 1878024 7451360 7 3680796 2059740 1934365 7674901 8 3791220 2121532 1992396 7905148 9 3904957 2185178 2052168 8142303 10 4022105 2250734 2113733 8386572 11 4142768 2318256 2177145 8638169 12 4267051 2387803 2242459 8897313 13 4395063 2459438 2309733 9164234 14 4526915 2533221 2379025 9439161 15 4662722 2609217 2450395 9722334 16 4429586 2687494 2523907 9640987 17 4695361 2768119 2599624 10063104 18 4883176 2851162 2677613 10411951 19 5078503 2936697 2757942 10773142 20 5281643 3024798 2840680 11147121 21 5492909 3115542 2925900 11534351 22 5712625 3209008 3013677 11935310 23 5941130 3305278 3104088 12350496 24 6178775 3404437 3197210 12780422 25 6487714 3506570 3325099 13319383 26 6812100 3611767 3424852 13848719 27 7152705 3720120 3527597 14400422 28 7510340 3831724 3668701 15010765 29 7885857 3946675 3778762 15611294 30 8280150 4065075 3892125 16237350 31 8694157 4187028 4008889 16890074 32 9400000 4300000 4125000 17825000 Sum 166355684 90554621 85521909 342432214 Mean 5198615 2829831.91 2672560 10701007 Std. devn. 1754997 765969 742068 3253095 Coeff.of variation= Std. deviation/Mean 33.76% 27.07% 27.77% 30.40% Difference from the consolidated figure -3.36% 3.33% 2.63% Relative variablity is measured by coefficient of variation,ie. Std. Deviation of various quarterly sales figures, as compared to the mean sales figure. When compared to the Consolidated sales revenues ,Variation from the mean sales revenues are to be understood as follows: Sales revenues of Defense varies more than that of consolidated revenues followed by sales revenues of Consumer products & lastly Industrial supplies. So, that which varies/sways more from the central figure ,is said to be risky. That means, defense is the riskiest . 2...To find the hurdle rate Julie must have used the CAPM model for calculating the cost of equity & along with after-tax cost of bonds would have found the weighted average cost which is done as follows: Cost of Equity as per CAPM ke=RFR+(Beta*Market risk Premium) ke=4%+(1.1*10%) 15% After-tax cost of debt= 11%*(1-40%)= 6.60% So, WACC= (Wt.e*ke)+(Wt.d*kd) WACC=(70%*15%)+(30%*6.6%)= 12.48% 3..“Pure play” approach to estimating the required return on an investment is to adopt the beta (for volatility or riskiness)of comparable firms (those whose business operations are on similar lines) while calculating the WACC as is given in the question itself---- "One way was to measure or collect the equity betas of comparable homogeneous companies and substitute those in place of the firm’s overall beta when calculating the weighted average cost of capital." 4. Using Julie’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, the divisional hurdle rates can be calculated as follows: Defense products----- 12.48%+3.36%= 15.84% Consumer Products-----12.48%-3.33%= 9.15% Industrial supplies-----12.48%-2.63%= 9.85% 5.. The above method of evaluating projects for the different divisions , using differential hurdle rates, seems to be justified as ultimately, it is the returns from investment that are going to justify the initial cashout- flows, namely the investment. But instead of study of the gross sales revenue ,as it is taken here , it can be the net after-tax earnings ,that follows the investment. This will ensure if the additional risk is adequately covered. 6...Evaluating the Net Present Values of the proposals at the overall WACC : Defense: -1400000+(400000*3.56232)= (PVOA F 12.48%,5 yrs.) 24928 Consumer Products: -1600000+(390000*4.05612)= (PVOA F 12.48%,6 yrs.) -18113 Industrial supply: -1800000+(396000*4.49512)= (PVOA F 12.48%,7 yrs.) -19932 Only the Defense project has positive NPV & hence recommended. Both the others should not be undertaken. 7...Evaluating the Net Present Values of the proposals with the Divisional hurdle rates: Defense: -1400000+(400000*3.28655)= (PVOA F 15.84%,5 yrs.) -85380 Consumer Products: -1600000+(390000*4.46593)= (PVOA F 9.15%,6 yrs.) 141713 Industrial supply: -1800000+(396000*4.89256)= (PVOA F 9.85%,7 yrs.) 137454 Defense project has Negative NPV because of the higher discount rate(to discount cash flows) used to counter the higher volatility & riskiness in generating sales & so not recommended. Consumer products products division project has the highest positive NPV followed by the Industrial Supply division's project.
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