Star A

As you read the Star Appliance A case, you will notice that it involves another firm in which the management has long-held customs about financial management.  In preparing and discussing the case, I want you to devote most of your time and attention to what is best for the shareholders of the firm (as a practicing financial manager should). This may or may not conform to management's custom.  When we have reached a conclusion about what is best for the shareholders, we will spend some time discussing whether management would agree to the recommendation and, if we feel they might oppose it, how we might try to convince them.  By the way, this is the approach I would like you to take throughout the course: concentrate on what is best for shareholders, and if, for example, you have some space left in your 2 page write-up, discuss possible management opposition.

Star Appliance Company

People:

• Arthur Foster; Financial Vice President of Star App. Company. He started in 1978
• Ken MacDonald; Founder of Star Appliance in 1922. Retired in 1963
• Chris Weeks; Star’s President. Joined as sales rep in 1955

Summary:

• Foster concerned about discount rate used in capital-allocation process. He thought the time had come to discuss company’s required rate of return on investment or “cost of capital” (opportunity cost of making a specific investment)

• Rate of return that could have been earned by putting the same money into a different investment with equal risk
• The cost of capital is the rate of return required to persuade the investor to make a given investment

• Star Appliance was founded in 1922 by Ken McDonald to manufacture electric stoves and ovens
• During 1920s, demand for electric stoves and ovens replaced wood and coal burning stoves
• Star Appliance became a respected brand name and market leader
• MacDonald financed the rapid growth through sale of common stock because the burgeoning equity market was growing
• Company entered Depression with a debt-free balance sheet
• Star suffered during Depression but was able to survive by reducing operations and concentrating sales efforts on the premium end (least affected part of market)
• Star remained alive and viable, coming out at the end of WW II with a smaller base of operations, strong balance sheet, and well-established reputation in the market place.
• Star continued to focus on premium market and over the years expanded its product line.

• Added gas ranges to products, followed by line of fridges, microwave ovens (newest product), etc

• Marketing program emphasized sale of new appliance as replacements for older models, rather than targeting market for installations in new constructed dwellings. This provided protection from cyclical housing industry
• Through period of growth, Star relied solely on equity to finance itself. MacDonald believed he had to continue to keep debt financing to a minimum
• Star’s premium image had allowed it to price its products to command a higher margin than its competition; as a result, all of Star’s equity financing had come from profits—additions to retained earnings
• Star had a liquidity reserve of cash and marketable securities. That meant that during seasonal and cyclical slumps, the company was able to draw on this reserve, eliminating the need to borrow
• Star had been able to maintain a stable work force which management believed contributed to its superior labour productivity
• On occasion, when Star had been limited by lack of internal funds, the company would temporarily reduce its liquid reserve to provide necessary funding
• Only 3 times since end of WW II had the reserve not been large enough and Star had sold new equity
• These marketing and financial strategies had created a strong company whose stock in 1978 was widely held by the investing public
• Chris Weeks believed that in order for Star to capitalize on market reputation and brand-name recognition, any new products should be kitchen oriented
• Desire to expand product line was in response to a general industry slump
• Stock price had fallen despite continued growth in sales and profits during a period when competitors’ sales and margins declined
• Management believed the company’s stock price had been adversely affected by industry’s problems.
• Introduction of new products might provide an impetus to stock market and increase the company P/E ratio back to normal
• Three new product lines:

• Dishwasher
• Food disposer for kitchen sinks
• Trash compactor

• Marketing dept believed each product had good sales potential and would fit company image of high-quality premium-priced kitchen products
• Exhibit 4 shows analysis following Star’s capital-allocation process. Also shows costs, benefits, expected lives, and terminal values

IRR:

• Using marginal tax rate, after-tax cash flows were used to calculate internal rate of return for each project
• IRR is then compared with the company’s 10% discount rate
• Accepted projects only if IRR exceeded discount rate if funds were available
• When capital is short, projects with highest IRR were implemented and lower return projects were postponed until funds available

Issues to be Addressed:

• Foster was concerned about the appropriateness of 10% required rate of return

• No source or precise reason of the rate
• Best guess is return on equity seemed to have been 10% during period when capital-budgeting system was being established and still being used

• Foster convinced discount rate was too low.

• Interest rate on US Treasury securities shown in Exhibit 5
• Treasury bills had recently exceeded 13%
• Study showed common stock historically had a return of about 8.5% above avg return on Treasury bills and 6% above LT Treasury securities
• Foster certain Star’s projects were more risky than T-Bills and thus, projects should have higher expected return if they were to be accepted
• Foster didn’t believe that Star’s stock was as risky as the avg common stock. This suggested that the full market risk premium would not be expected by investors in Star’s common stock.

• Manufacturing company where Foster worked before Star, implemented a dividend-growth model in calculating the cost of equity. See top pg 56
• Star’s current stock price was $22.50 and company’s management and board of directors intended to continue its policy of maintaining or slightly increasing dividends. See Exhibit 6 for Star’s stock and stock market
• Because Star had only ST debt, Foster didn’t believe cost of debt should be considered in calculating return required by Star’s capital providers

• If an all-equity financed firm was less risky in economic turndowns, why would required cost of capital be higher?
• Debt cost less than equity (taxes) and the use of debt would reduce a company’s overall avg required rate of return

• Foster wondered whether inflation was properly accounted for in Star’s present system?
• Foster wondered whether Star should accept projects that just met the required rate of return or only those that exceeded it by a margin of safety?
• Discount rate should cover investments in safety and environmental projects to satisfy US gov’t’s increased requirements (nonproductive investments = investments with no return)

• Failing to cover those investments would guarantee that Star would earn less than its required rate and affect shareholders

• Staff believed two of the projects were riskier than the other one because:

• New plant and equipment were required that would add appreciably to fixed costs

• In downturns or unsuccessful projects, it would cost Star more and staff thought the rate required should be increased to compensate risk
• Although star had built up its liquid reserves in the expectation of launching new products, whether all 3 could be financed internally was questionable.

• Depreciation would have to be reinvested to maintain Star’s current production facilities.

Industry:

• The modern major appliance industry has its roots in the American consumer-products boom of the 1950s
• By that time most major appliance products originated in the US
• Ups and downs of the industry and the recession of the early 1980s
• In the mid 1970s, Federal gov’t had begun to urge the industry to consolidate to achieve greater economies of scale and become more competitive

• Star increased its investment in safety and environmental projects to satisfy US gov’t’s increased requirements (categorized them as nonproductive investments, no return)

• In 1952, refrigerators began to be produced with an automatic ice maker. A few years later, the magnetic strip that helps to keep the doors closed tightly was standard on new refridgerators
• By 1970s, dishwashers had become quite common in American households and are popular today due to all of their advancements and luxury they provide
• In 1967, countertop sized microwaves were available for kitchens
• Americans are eagerly awaiting the next new thing to make their life more hassle-free.
• Most evident with infomercials which are constantly praising the ease of new kitchen products.

Approaches:

• Star Appl is looking to expand their product line and is considering 3 different projects: dishwasher, food waste disposal, trash compactor
• Need to determine the value of each project and which ones are worth doing by determining if they will add value to Star; The projects that add the most value will be worth pursing. Staff has made forecasts that 2 of the projects are riskier than the other.
• Current discount/hurdle rate is 10% and Foster (Finance VP) is concerned that is might not be appropriate since there is no source for the rate. Therefore, hurdle rate should be re-calculated by finding the weighted average cost of capital (WACC). Then by forecasting the cash flows of each project and discounting them by the WACC to find the net present value (NPV), or by solving for the internal rate of return (IRR), you can tell which projects Star should undertake.
• Rate of return that could have been earned by putting the same money into a different investment with equal risk
• The cost of capital is the rate of return required to persuade the investor to make a given investment
• Calculate the NPV and IRR for each project to determine the value of each one and which one will be positive/profitable
• In order to create an optimal capital structure, an analysis can be used to determine how the capital budgeting decisions should be proportioned
• Currently Star has no debt in their capital structure, so the new projects should begin to incorporate debt to the company

• Capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or LT notes payable, where equity is classified as common stock, preferred stock, or retained earnings
• Main benefit of increased debt is the increased benefit from the interest expense as it reduces taxable income. Stockholders become nervous because if interest increases, EPS decreases and a lower stock price is valued.
• An optimal capital structure is combination of both equity and debt that maximized earnings and stock price. Best implied by the capital structure that minimizes the company’s WACC.