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Star Appliance Company A Case Solution & Answer

Star Appliance Company A Case Solution 

Introduction

The Star Appliances Company Case is about the decision of organization’s financial vice president Arthur Foster to expand its product line. The company was founded in the year 1922 by Ken McDonald. The company was mainly engaged in the manufacturing of oven and electrical stoves. Arthur Foster proposed that the company must add garbage disposals, dishwashers, and trash compactor to its product line. As compared to its competitors the company have always relied on equity-based financing that is why the company is evaluation the cost of equity of all three projects by comparing future cash inflows from either 10% hurdle rates or internal rate of the returns given per project. (Harrington, 1991)

Q 1: Methods to Determine the Cost of Capital for Star

To determine cost of capital of the company, Mr. Foster the financial vice president of the company can use various methods like:

  • Company’s Discounted Cash Flows (DCF) method.
  • The Dividend Growth Model
  • Capital Assets Pricing Model.
  • Or Fama French.

Q2: Assumptions for Using These Methods

The Dividend Growth Model:

  • The growth rate for dividends is constant.
  • The growth rate would be always less than or equal to the required rate of return.
  • The required rate of return used by investors would be always certain and constant.

Capital Assets Pricing Model:

  • By using this method firm’s required rate of return could be determined.
  • As the firm only implement equity-based financing for its capital expenditures, hence the cost of capital equals the cost of equity determined using this method.
  • And for that the aspects of risk and returns are must to consider.
  • According to these assumptions firm’s expected return ≥ required rate of return

FamaFench:

  • The method is actually derived and expanded form of capital assets pricing method (CAPM) including the factors of size and value besides risk and return factors.
  • It is assumed that the value and the small cap stocks would perform better than the market regularly.
  • Requirement for adjusting small cap and value stocks’ performance.

Enterprise DCF:

  • This model is used to determine the discounted free cash flows of the considered projects. There is no assumption used in this model, whereas using this method could be effective by taken in consideration the accuracy of all the variables in the model.

Q3: Which Methods Are Appropriate For Mr. Foster To Use At Star?

The Discounted Cash Flows model is most appropriate method that the company should consider.  Because there are no assumptions used in this model and the cash flows are discounted at their present value the compared with the present values of other projects.

Q4: Analyzing at 10 Percent Hurdle Rate

The 10% hurdle rate must not be considered by the company in their capital expenditures related decision making processes. This rate was used by the firm from its very beginning, then the firm was dealing with depression, hence its recalculation is highly recommended for accurate value of cost of capital used for firm’s investment related decision making in accordance to the economic conditions.

Q5: Analysis of Current Cost of Capital the Appropriate Hurdle Rate for Evaluating New Investments

The presently used rate by the firm for its capital expenditures related to new projects is relatively very low. But if it is recalculated, the accurate rate could be find in order to determine the net present value NPV of all the projects and decisions could be suggested.

Q6: Star Management Do With Regard To the Three Proposed Investments (Conclusion)

For the purpose of answering this section following quantitative analysis has been done. Firstly the firm’s cost of capital is calculated considering the value of cost of equity calculated by using Gordon Growth Model i.e.

Cost of Equity (Ke) = Dividend yield (d) + growth rate (g)

The dividend yield for the company is computed by dividing the stock price of the company i.e. $ 22.50 with the dividend per share of the year 1980 i.e. 1.70.  Besides this the company’s growth rate is determined by takin average of growth rates for dividend and EPS……………………

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