Star Appliance

Star Appliance Case Study

Situation:

Star Appliance is looking to expand their product line and is considering three different projects: dishwashers, garbage disposals, and trash compactors. We want to determine which project would be worth doing by determining if they will add value to Star. Thus, the project(s) that will add the most value to Star Appliance will be worth pursuing. The current hurdle rate of 10% should be re-evaluated 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, or by solving for the internal rate of return, we should be able to see which projects Star should undertake.

Conclusion:

Which Projects?

After calculating the Net Present Value (NPV) and the Internal Rate of Return (IRR) for each project, I have determined that both the dishwasher and the trash compactor projects should be pursued. Both of them have shown positive NPVs at the new discount rate of 11.58% (WACC). Another indicator that told me that these two projects should be pursued by Star was that they both yielded IRRs greater than the given hurdle rate. The disposal did not meet these requirements and therefore should not be undertaken.

How to Fund the Projects?

Based on the optimal capital structure analysis, they should pursue as 70% debt proportion, which will give them the lowest cost of capital at 11.58%. Currently Star has no debt in their capital structure, so these new projects should begin to add debt to the company. However, no matter what debt and equity proportions are chosen for each project, the discount rate of 11.58% should be used, as the capital budgeting decisions should be independent of the financing decisions.

Cost of Capital: Current Capital Structure

Gordon Growth Model: (Re = Div Yield + g)

I first solved for the dividend yield by using the equation of next year's dividend divided by this year's stock price. The current year is 1979, so from Exhibit 3 the 1980 dividend is forecasted to be $1.70, and the stock price in 1979 is $22.50. This gives a dividend yield of 7.56%, which is added to g. There are four ways to solve for g:

* Dividend Growth Rate: Using the dividend schedule data in exhibit 6, g = 4.46%

* Capital Gains Yield: I was able to find the stock prices by multiplying the P/E ratio times EPS, both of which are found in exhibit 6. g = 1.90%

* EPS Growth Rate: These values are also found in exhibit 6, leading to g = 5.55%

* Reinvestment Returns: I found "b" (the reinvestment rate) by using exhibit 1 to calculate the percentage of net income per share of common stock that is paid out in dividends, and subtracting it from 1 to solve for the percentage reinvested. The return on equity, "k", is found by dividing net income (exhibit 1) by book value (exhibit 2). G = b*k shows g = 8.14%.

Now to find the return on equity (ROE), I chose to add the average of the Dividend Growth and the Earnings Per Share Growth and use that as g. I decided that the Capital Gains Yield was much too low compared to the other values of "g" that I found and should be discarded from further calculations, considering it to be an outlier. The Reinvestment Returns yielded a value for "g" that is a little on the high end, but it is only based on the 1978 numbers, so they might not be accurate numbers to use for future predictions. EPS growth and Dividend growth have both grown proportionally with Star, so they would be the best choices. The use of these values also seems to be sensible because if the growth of dividends were higher than the growth of earnings, then this level would not be sustainable for a long period of time, if at all. When added to the dividend yield, the return on equity is found to be = 12.56%.

CAPM: Re = Rf + B(Rm - Rf)

The most difficult part of finding the return on equity using the CAPM was solving for Beta (B). I did this by calculating a regression of the market returns each year vs. the returns yielded by Star Appliance. The market returns were listed in exhibit 6 were the values that I used. Star's returns were found by multiplying the EPS times the P/E ratio to get the year's stock price. I then found the change in the price each year, which is the capital gain yield (CGY). Adding this, the CGY, to the dividend yield (also listed in exhibit 6) gave Star's returns. The results of the regression were a best fit line with a slope of 0.831, which equals beta. Using exhibit 5, I averaged the 10 and 20 year T-bill rates to get "Rf" for 15 years of 10.7%. I used the given 6.0% percent as the market premium. Putting all of these values into the CAPM equation gave a return on equity of 15.69%.

Optimal Capital Structure

WACC = (D/D+E)(Rd)(1-t) + (E/D+E)(Re)

Even though Star originally has a debt-free capital structure, there is an optimal capital structure that includes debt, which is usually a cheaper source of financing. To find the weighted average cost of capital, I first calculated the cost of debt using the spread between bond debt ratings (what was the spread?). I added the spread to the risk free rate of 10.7% used earlier as "Rd", then multiplied this value by (1-tax rate) to find the cost of debt. Next, I had to find a beta for the levered Star by using the equation BL=BU(1+(1-t)(D/E)). I determined the debt/equity ratio by solving (D/D+E) =((D/D+E)-1)^-1. Now I used the CAPM again to solve for Re of the levered firm for different proportions of debt. Finally, the WACC was found by multiplying the cost of equity times the proportion of equity plus the cost of debt times the proportion of debt. We want the lowest WACC, as that is the lowest cost to star for their capital structure. This analysis shows Star's optimal structure to be at 70% debt, 30% equity, with a WACC of 11.58%.

Capital Budgeting

Cash Flows:

I found the cash flows of all 3 projects