CHESTNUT FOODS Case Solution
Moreover, if a single hurdle rate is used then the company would be under investing in low risk projects and it would be over investing in high risk projects. Then a time will come when the required rate of return of the investors for their risk would not be compensated by this constant hurdle rate. Therefore, all the assertions laid down by Meyer are logical and based upon sound rationale.
Risk Adjusted Cost of Capital for Two Divisions
The risk adjusted cost of capital for the food processing division and the instruments division has been estimated using the information of the comparable companies in both of these divisions. The average equity beta of the comparable companies, the average capital structure comprising of debt and equity has been used in order to estimate the cost of capital for each of the divisions.
The use of the separate equity betas for both the industries would incorporate different risk of the separate industries in their individual cost of capitals. The market risk premium is taken to be 6% and the risk free rate taken is 2.8%. The tax rate is 37%. The cost of equity has been calculated based upon these assumptions. In order to determine the after tax cost of debt, the cost of debt before tax for each of the divisions has been assumed on the basis of the credit ratings.
Majority of the companies in the food processing division have a credit rating of BBB+ therefore, the cost of debt corresponding to this rating has been used for this division which is 3.8%. Similarly, the credit ratings for most of the companies in the instruments division are between BBB and BBB- therefore, the average of the cost of debt for these two credit ratings has been used as the cost of debt for the instruments division. Based upon this information, the risk adjusted cost of capital for the food processing and the instruments division is 4.10% and 7.23% respectively. If we compare these cost of capitals with the constant cost of capital of 7% then it could be said that in both the cases, the valuation of the company was not appropriate and the main reason for the company’s decline in the instruments division is over investment in high risk projects.
Lastly, if we comment on the graph created by Meyer then it could be said that although the hurdle rates are different which might be due to the changes in the assumptions, but this graph clearly provides evidence that the instruments division had been over investing in high risk projects. Moreover, the instruments division is also much riskier as compared to the food processing division of the company and if the company had been using the hurdle rate of 7% then the un-adjustment of the risk was being treated as a hidden cost and the management was fooling themselves. Finally, since the foods processing division generates 20% revenue for the company and the remaining revenues is generated by the instruments division therefore, the weighted average cost of capital for Chestnut Foods Company as a whole has also been calculated as shown in the excel sheet which is 6.6%.
Constant VS Risk Adjusted Hurdle Rates
The net operating profit for the year 2013 for the food processing and the instruments division is $ 88 million and $ 46 million respectively. Since, there is none additional information available for calculating the cash flows therefore, it has been assumed that these are the final free cash flows for 2013 for each of these two divisions……………
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