Wendy Cheung was at it again! It seemed like she was causing troubles wherever she went. At her previous job, Wendy had successfully persuaded the top management to implement a system that recognizes the differential risks for different divisions and evaluate projects based on risk-adjusted hurdle rates. However, the change caused so much unpleasantness among divisional heads that Wendy was forced to quit the job.
At her current job as Finance Manager for System Ltd., Wendy had to evaluate proposals that came from the firm’s three product divisions; Government, Consumer Products, and Industrial Supply. During her 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).
System employed 100 people and manufactured high quality storage units made from aluminum, plastic, and wood. The Government division accounted for around 75% of the sales volume, while the other two divisions split the balance.
Being unclear as to what the policy was regarding the hurdle rate to be used in evaluating such projects, Wendy determined to calculate the firm’s weighted average cost of capital herself. After carefully analyzing the firm’s financial statements and talking to the underwriters, Wendy gathered the following information:
The ordinary share of System sells for $37.14, and last year’s dividend was $2.10.
System’s preferred share pays a dividend of $3.30 per share, and new preferred share could be sold at a price to net the firm $30 per share.
Security analysts are projecting that the cash dividend to ordinary share will grow at a rate of 7 percent a year.
The firm can issue additional long-term debt at an interest rate (or before tax cost) of 10 percent.
The marginal tax rate is 35 percent.
The market risk premium is 6 percent, the risk-free rate is 6.5 percent, and System’s beta is 1.092.
System has a target capital structure with 45 percent debt, 5 percent preferred share and 50 percent ordinary share.
Wendy decided that she had better figure out a logical method of adjusting the divisional hurdle rates, because she believed that failure to do so would result in the firm making unwise capital budgeting decisions. She approaches her boss, Martin Chan, and said, “We are not all alike and we should not pretend to be. Don’t you agree?” To her relief, Martin agreed. So Wendy went to work.
She remembered that there were several ways she could go about doing the adjustment for differences in risk across divisions. One way was the “pure play” approach. The other way was to simply adjust the firm’s weighted average cost of capital up or down based on the judgment of each division’s risk. After doing some research on the Internet, Wendy estimated the following adjusted betas using the “pure play” approach for the three divisions: (1) Government: 0.422, (2) Consumer Products: 1.756 and (3) Industrial Supply: 2.428.
After doing some quick calculations, Wendy sent off emails to the Managers of the three divisions setting up a time for a meeting. Somehow, Wendy knew that it was not going to be a pleasant meeting.
Table 1
Projected Costs, Lives, and Cash Inflows of Divisional Proposals
Division / Cost / Life /Annual Net Cash Inflow
Government / $(1,000,000) / 5 / $256,000
Consumer Products / $(1,000,000) / 6 / $250,000
Industrial Supply / $(1,000,000) / 7 / $217,000
Required:
1) Determine the hurdle rate for the entire company.
2) What is meant by the “pure play” approach to estimating the required return on an investment?
3) Using the data gathered by Wendy for the “pure play” approach, calculate the divisional hurdle rates.
4) Using the firm’s overall weighted cost of capital evaluate the three divisions’ project proposals. What are your findings?
5) How are the decisions affected when the divisional hurdle rates are used instead?
6) Determine the amounts of annual net cash inflow for each division that result in a zero NPV based on the divisional hurdle rate. How are you going to explain to the division managers your findings?