Numbers 5,6,7 please i have answers for the first four. thanks! 1) Using STDEV.P
ID: 2819714 • Letter: N
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Numbers 5,6,7 please i have answers for the first four.
thanks!
1) Using STDEV.P function in excel, standard deviation for each division and consolidtaed is calculated
Using VAR.P function in excel, Variance for each division and consolidtaed is calculated
Std Dev / Average gives Coefficient of variation CV for each division
Ratio is given by CV for each division/ CV consolidated
The result shows that Defense is riskiest division as indicated by CV ratio of 1.10 which means that sales of Defense is 10% more riskier than that of consolidated firm
2) Hurdle rate = Weighted average cost of capital (WACC)
WACC= Weight of debt*After tax cost of debt + Weight of equity * cost of equity
Debt=30%, so equity = 100%-Debt = 100%-30%=70%
After tax Cost of debt = (1-tax rate)*Yield to maturity = (1-0.4)*11% = 6.6%
Cost of equity = Risk free rate + Beta*Market Risk premium = 4%+1.1*10%=15%
WACC = 0.3*6.6% + 0.7*15% = 12.48%
3) Pure Play company is a company that focusses on single line of business. Pure play approach means that when a company has multiple division, the cost of capital for one particular divison can be calculated by finding a company whoose sole business is same as that of division and then use its cost of capital to calculate the required return from that divison
4) WACC =12.48%
So for Defense Division, hurdle rate = WACC*CV ratio =12.48%*1.1=13.86%
For Consumer Product, hurdle rate = 12.48% * 0.89 = 11.11%
For Industrial Product, hurdle rate = 12.48% * 0.913 = 11.40%
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, sheExplanation / Answer
(5) Pure Play firms are those which are focussed on only a single business line/product and are present in a single sector/industry, thereby lacking any form of vertical integration/diversification. Consequently, investing in pure play companies is akin to investing in the particular commodity/product/sector and hence the cost of capital of the pure play company is a good approximation of the costs involved with investing in that particular sector/commodity/product.
In this context, the endeavour to invest in defence, consumer goods and industrial supply requires individual costs of capital which can be best approximated by looking at pure play companies from the relevant sectors. Further, the pure play approach cost of capital (cost of equity) comprises of the unlevered beta (signifying business risk of that particular business) and the debt-equity ratio of the firm (signifying financial risk of the particular firm under consideration), thereby making the pure play cost of capital a good approximation and not an exact match. This is so because the debt-equity ratio of the pure play firm and division under consideration will be different, even though their unlevered betas (business risks) are the same.
Hence, the pure play approach of determining departmental hurdle rates is a recommended method most of the time except when the debt-equity ratio of the pure-play firm and the department under consideration diverge by a large magnitude.
(6) Using the overall WACC would imply a discount rate of 12.48 %(=WACC)
Defense:
Initial Investment = $ 1400000, Project Life = 5 years and Net Annual Cash Flow = $ 400000
NPV = 400000 x (1/0.1248) x [1-{1/(1.1248)^(5)}] - 1400000 = $ 24927.91 approximately.
Consumer Products:
Initial Investment = $ 1600000, Project Life = 6 years and Net Annual Cash Flow = $ 390000
NPV = 390000 x (1/0.1248) x [1-{1/(1.1248)^(6)}] - 1600000 = - $ 18114.6 approximately.
Industrial Supply:
Initial Investment = $ 1800000, Project Life = 7 years and Net Annual Cash Flow = $ 396000
NPV = 396000 x (1/0.1248) x [1-{1/(1.1248)^(7)}] - 1800000 = - $ 19930.6 approximately.
As the NPV is positive (value additive) only in case of the Defense department project, the same should be selected and the other two projects (in the other two departments) must be rejected.
(7) Defense:
Hurdle Rate = 13.86 %, Initial Investment = $ 1400000, Project Life = 5 years, Net Annual Cash Flows = $ 400000
Therefore, NPV = 400000 x (1/0.1386) x [1-{1/(1.1386)^(5)}] - 1400000 = - $ 22134.4 approximately.
Consumer Products:
Hurdle Rate = 11.11 % , Initial Investment = $ 1600000, Project Life = 6 years, Net Annual Cash Flows = $ 390000
Therefore, NPV = 390000 x (1/0.1111) x [1-{1/(1.1111)^(6)}] - 1600000 = $ 44694.63 approximately.
Industrial Supply:
Hurdle Rate = 11.4 %, Initial Investment = $ 1800000, Project Life = 7 years, Net Annual Cash Flows = $ 396000
Therefore, NPV = 396000 x (1/0.114) x [1-{1/(1.114)^(7)}] - 1800000 = $ 42158.21 approximately.
As the Consumer Products and Industrial Supply department projects have positive NPVs or are value accretive in nature, the same should be selected over the Defense department project.
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