Star a Company

Star A Company

Issue

The company’s rate of return on investment.

History

• Electric stoves and oven producer
• Financed through common stock
• Survived depression from reducing its operations and concentrating its sales on the least affected part of the market (premium market)
• Expanded in kitchen appliances

Evaluating Product Expansion

• Thought introducing new products will bring the P/E ratio back to normal
• Dishwasher, food disposer, trash compactor
• Results of the costs, benefits, expected lives, and terminal values are shown in exhibit 4
• Marginal tax rate, after-tax cash flows used to calculate the IRR for each
• IRR then compared to 10% discount rate
• Accepted projects above discount rate as long as funds were available
• In years when capital was short only the highest IRRs were accepted, other projects were held until funds were available
• Foster was convinced the discount rate is too low
• Treasury bill securities exhibit 5
• T bills had recently exceeded 13%, common stock 8.5% higher than average t-bill return, 6% higher than long term t-bill
• Project was riskier than t-bill therefore should have higher rate
• Foster did not believe riskier than common stock  (t-bill
• Dividend growth model used to calculate cost of equity
•  Current stock price $22.50 and continue to slightly increase dividends
• Star’s historic dividends, other info about stock and stock market in exhibit 6
• Only short term debt, therefore does not consider cost of debt in calculating the return required by capital providers

• Was inflation adequately accounted for in star’s present system? (exhibit 5 & 6) believe that the rates on US treasury securities included return to offset expected inflation, was that enough?
• Wondered whether star management should accept all projects that just met the required rate of return or only those that exceeded it by a margin of safety
• Should required rate be raised to compensate for poor forecasts
• Increased its investment in safety and environmental requirements
• Increase discount rate to cover env investments or else shareholders would get hurt
• Two projects were riskier than the other one because they required new equipment and new plant that would add to fixed costs
• Rate increase to account for risk or rated on strategic importance

Conclusion

• Depreciation would need to be reinvested to maintain star’s current production facilities
• $12m from operations in ’79  
• $15-20m by reducing cash and marketable securities
• If all 3 approved could need as much as $40m in external financing
• If management decided just the dishwasher, require $3m in new funds
• Confident would be able to sell a reasonable amount of new equity, to net, after issue costs, about 95% of the current market price
• Not certain whether the issue costs should be included in his evaluation of the company’s required rate of return