Case (We are Not All Alike)
1. Using the data given in Table 2, determine the relative variable of each division's sales as compared to that of the consolidated firm. Which one is the riskiest and why?
The calculations show that the defense products division is the riskiest of the three. Its sales are about 11% riskier than the consolidated sales of the firm. This is shown by the coefficient of variation of its sales relative to that of the consolidated sales figures.
2. Explain the process by which Pamela must have determined the hurdle rate for the entire company. The corporate tax rate was 40% the yield on outstanding bonds was 11%, treasury bills were yielding 4% and the market risk premium was estimated at 10%. The company currently had 30% of its capital in the form of debt and the remaining in the form of common stock.
Hurdle rate= Weighted average cost of capital (WACC)
WACC= Weight of debt * after tax cost of debt + weight of equity * cost of equity After Cost of the equity= yield to maturity * (1-Tax) = 11% (1-4) =6.6% And cost of equity= Risk free rate + (market risk) * Beta=
=4% + 10% (1.1)= 15%
3. What is meant by the "pure play" approach to estimating the required return on an investment?
A company that focuses on a single line of business os called a "pure play" When firms have multiple divisions, one way of trying to estimate the divisional costs of capital is to find companies that focus as exclusively as possible on the type of business that the division is involved in (pure play companies) and use their required rate of return.
4. Using Pamela's methodology of adjusting the firm's hurdle rate based on the relative variable of each division's sales in relation to that of the consolidated firm, calculate the divisional hurdle rates.
WACC(defence products) = 12.48% * 1.11 = 13.86
5. Comment on this methodology of...