Star Appliance Company (A) Case Solution

Analysis of current cost of capital the appropriate hurdle rate for evaluating new investments

The current hurdle rate is relatively very low for the risky investment decisions of including the dishwashers, garbage disposals, and the trash compactors. After the re-calculation, the appropriate discount rate could be achieved which should be used for calculating the net present value for each of the three alternatives in order to make some recommendations.

In order to answer this part, the quantitative evaluation is required in order to come up with some recommendation for the company. The first and the foremost step required to perform this analysis is to compute the appropriate cost of capital for the company. For this, the cost of equity is computed with the help of Gordon Growth Model, the formula applied is as follows:

Cost of Equity = Dividend yield + growth rate

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. In addition to this, the growth rate for the company is computed by averaging the dividend growth rate, capital gains yield, EPS growth rate and the reinvestment returns for the company. With the help of all the above calculations, the cost of equity is computed to about 12.57%, since the company is currently using only equity capital in its overall capital structure so this cost of equity is equal to the cost of capital for the company.

In order to evaluate each of the three alternatives, DCF approach as proposed by the company is used. The free cash flows of the company are computed with the help of after tax flows of each of the three different projects. The depreciation of plant and equipment are adding to these cash flows to come up with the operating cash flows. From these values the changes in net working capital are subtracted to come up with the free cash flows of the company.

These values are discounted back to the present value with the help of the new discount rate which concludes the fact that project dishwasher should be added to the current product lines of the company, since it has a higher Internal Rate of Return as compared to all the other investment decision. In addition to this, it is also higher from the new discount rate calculated. The project also yields positive net present value as compared with the other investment which also strongly suggests that the project should be accepted.

Gordon Growth Model  
   
Dividend Per Share  $       1.70
Current Stock Price  $    22.50
Dividend Yield 7.56%
   
Growth  
Dividend Growth Rate 4.46%
Capital Gains Yield 1.90%
EPS Growth Rate 5.55%
Reinvestment Return 8.14%
Average 5.01%
   
Cost of Equity 12.57%
   
Cost of Capital 12.57%

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