Paraphrase

Star Appliance Company: Part A

Arthur Foster is concerned with Star Appliance’s 10-percent discount rate. This would be compared to their three new product lines. He is concerned that the discount rate is too low thus resulting in inaccurate results of IRR and NPV. Another area of question that arises is that should Star Appliance accept projects that merely meet the required rate of return or should they implement a safety margin that must be exceeded first.

To calculate a new discount rate that would better fit the company, Foster must calculate the weighted average cost of capital (WACC). Since Star Appliance is all equity and no debt, only the equity will have weight in the formula. This is calculated as follows, WACC = (E/V) * cost of equity + (D/V) * cost of debt * (1-corporate tax rate). We will have to calculate the cost of equity and cost of debt. The cost of equity can be calculated using the Dividend Discount Model. The equation is as follows, [(Dividends per Share/Current Market Value of Stock) + Growth Rate of Dividends]. In order to find the growth rate of dividends, we must use the equation, (Growth Rate = Plowback Ratio * Return on Equity). After finding the growth rate, plugging it back into the Dividend Discount Model, and plugging those numbers into the WACC formula, we can derive a new cost of capital.

In order to determine which projects of the new product line would be profitable, Foster should perform a Net Present Value Analysis. Doing so requires initial investment, cash flows for each year, and the use of the newly calculated cost of capital. They should accept the projects if they are a positive NPV, and reject if they are a negative NPV. By going an extra step, Foster can also calculate the IRR of each project to also measure the profitability of these investments. In order to see if these projects meet or exceed the required rate of return, Foster should also implement the Capital Asset Pricing Method (CAPM) to solve for the rate of return. This is done by using the following equation, [(Risk Free Rate + Beta of Security (Expected Market Return – Risk Free Rate)]. By comparing the NPVs, IRRs, and expected returns, Star Appliance should be able to decide which projects should be further undertaken. Implementing a safety margin would always be a safer and conservative option to account for any possible analytical errors.

Star Appliance Company: Part B

Star Appliance has recently purchased Rhinescour Company by contracting long-term debt of $17.8 million. Arthur Foster is curious in reevaluating the company’s cost of capital since taking on the debt. The three methods proposed include the Dividend Discount Model, the Earnings/Price Model, and the CAPM model.

In order to choose which method is more reliable, we would apply each one to Star Appliance’s company first and evaluate which one provides the most accurate estimate. However, CAPM would probably be the most accurate method because it accounts for beta. In order to find beta, we would have to run a regression using the given historical company and stock market data. By plugging the numbers into the CAPM equation, we are given a cost of equity number. With this, we can plug it into the Weighted Average Cost of Capital (WACC) equation.

We know Star Appliance’s debt to capital ratio, the borrow rate, and the cost of equity which we just calculated. Judging by the income statement given, we can assume the corporate tax rate to be 45%. By plugging these numbers into the WACC formula, we are given a new cost of capital. Foster also wanted to determine Star’s new cost of capital if they were to borrow up to the industry average of 19 percent as well. By increasing the debt ratio in the WACC formula, it will create a lower cost of capital.

Star Appliance was also contemplating on two strategic moves that would help grow the company: increasing plant capacity to produce more refrigerators in an attempt to create more market share, or expanding into the new product, grain dryers. As stated in the case, increasing capacity for refrigerators would result in a positive NPV of 14.5%. The new product of grain dryers would also result in a positive NPV of 17.2%. With the given betas of the home appliance industry and the agricultural industry, we can plug these numbers into CAPM and then apply WACC once again for each industry. In order to see which projects should be pursued, we can compare the WACC and the projects IRRs. Foster believed that the grain dryer would be the riskier option of the two, and this is true because this product does not fall into Star Appliance’s specialty of home appliances.