Enzone Petroleum Corporation
CASE CONTEXT:
Formed in1924 with the merger of several formerly independent firms operating in the oil refining, pipeline transportation, and industrial chemical fields.
All computations were based in 1975 data
PROBLEM:
Determination of a minimum acceptable rate of return on new capital investments in 1975.
Should the company adopt a system of multiple cutoff rates?
FRAMEWORK OF ANALYSIS:
WACC
Return on Assets
Cost of Common stock equity
ANALYSIS: The management of Enzone Company is in a debate of whether to use the constant minimum rate for evaluating operations and investments, 10% since 1966, or have multiple cutoff rates per division. They also believe that rates should already be adjusted because of inflation and different market inefficiencies. Also, they argue that risk return relationship will be more effective using multiple rates for the different divisions because each one employs a unique level of risk. Proponents of both sides gave their arguments and all have its points.
DECISION:
Based on the data provided, we decided that the company should implement a single rate of return, from 10% to the adjusted rate of return of 12.22%. Also, its weighted cost of capital should also be adjusted from 8.25% to 10.28%.
JUSTIFICATION:
New after tax cost Weighted cost
Debt 25% 4.45% 1.1125
Retained earnings 65% 12.22% 7.943
New Equity 10% 12.22% 1.222
New weighted average cost of capital 10.28%
4.45% is the new after tax cost of debt for an AA rating bond in 1975. 12.22% was computed using the risk free rate of 5.2% adjusted for beta of .90 and expected return of 13%.
Although the criteria were given in detail and provided with a limited data, we really cannot compute or multiple rates of return. We can also say that this single rate is adjusted for risk using the beta factor. This is also the average of the proposed multiple rates so risk will be
Formed in1924 with the merger of several formerly independent firms operating in the oil refining, pipeline transportation, and industrial chemical fields.
All computations were based in 1975 data
PROBLEM:
Determination of a minimum acceptable rate of return on new capital investments in 1975.
Should the company adopt a system of multiple cutoff rates?
FRAMEWORK OF ANALYSIS:
WACC
Return on Assets
Cost of Common stock equity
ANALYSIS: The management of Enzone Company is in a debate of whether to use the constant minimum rate for evaluating operations and investments, 10% since 1966, or have multiple cutoff rates per division. They also believe that rates should already be adjusted because of inflation and different market inefficiencies. Also, they argue that risk return relationship will be more effective using multiple rates for the different divisions because each one employs a unique level of risk. Proponents of both sides gave their arguments and all have its points.
DECISION:
Based on the data provided, we decided that the company should implement a single rate of return, from 10% to the adjusted rate of return of 12.22%. Also, its weighted cost of capital should also be adjusted from 8.25% to 10.28%.
JUSTIFICATION:
New after tax cost Weighted cost
Debt 25% 4.45% 1.1125
Retained earnings 65% 12.22% 7.943
New Equity 10% 12.22% 1.222
New weighted average cost of capital 10.28%
4.45% is the new after tax cost of debt for an AA rating bond in 1975. 12.22% was computed using the risk free rate of 5.2% adjusted for beta of .90 and expected return of 13%.
Although the criteria were given in detail and provided with a limited data, we really cannot compute or multiple rates of return. We can also say that this single rate is adjusted for risk using the beta factor. This is also the average of the proposed multiple rates so risk will be