Star Appliance Company

This paper will discuss how Star Appliance Company managed its cost of capital and plan for future investments. The paper will reveal corporate problems and present relevant management theories to lead the company into a solution. The underlying problems consist of choosing a new and more efficient financing strategy, and designing more accurate method of evaluating investment projects. Previously, the company was having positive sales performances which indirectly cause the problem to be hard to identify.

However, as the company needed to expand their business, the new financial officer discovered several inefficiencies in managing corporate financing strategies and evaluating future investment.

The condition was described by the WACC method.  The paper will present alternatives of solutions for the problem and in the end choose the most beneficial one for the case.

The company must adopt a new financing strategy which incorporates a balanced proportion between debt and equity financing instruments. The company must also design a new evaluation strategy for the new investment projects which incorporate risks premiums, additional cost of investments and a margin of error in forecasting future cash flow.

The financial department has obtained increasing roles in the corporate management concept. In previous times, marketing department projects sales, production department determined the necessary amount of assets required in order to meet the projections, and the financial department’s function was only to provide funds for providing other department with their requirements. However, this model of management is obsolete and replaced by more coordinated types of decision making, where financial managers are responsible for planning as well as controlling activities.

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This reflects the increasing importance of good financial considerations in each decision of the corporation.

According to Weston and Brigham (1996), there are several detailed activities related to financial management. One of them is the activity of making investment and financing decisions. In line with corporate long term strategy, financial managers must provide funds to support growth. Successful companies usually have high rate of sales, which required additional factory investment, equipment and current assets to produce goods and services.

In the more coordinated decision making activities, financial managers must help determining the optimum sales level and make decisions on specific investment that will be performed. Within those activities, there are also questions of whether to use internal or external financing, debt or equity financing, and short or long term debts. These are important aspects of corporate management that could determine whether the company is heading to success or financial failure.

Within this paper, I am discussing the importance of considering cost of assets in corporate financial management. The case study will be the Star Appliance Company in 1977. In this paper, I will describe the problems within Star Appliance Company financial management and offer recommendation to solve existing problems within the company.

II.                 Problems Within the Star Company

II.1      Corporate Background

The Star Appliance Company is a successful business of manufacturing home appliances, especially electric stoves and ovens. Soon after the company was established in 1922, it receives a warm welcome from the growing market for home appliances. The company focuses on providing its customers with premium types of home appliances with a slightly higher margin than its competitors.

In a short time, the company managed to gather significant market share due to its reputation of providing high quality appliances. Corporate financial strategy –to use equities instead of debts- has seemed to be working splendidly as The Company was able to survive the great depression and maintain its existence with smaller-based operations but strong financial structure within the company. However, management has become aware that there are problems in maintaining profitable operations with existing lines. The company plans to enrich its product lines, but there are some concerns regarding how the company managed its cost of capital. Without strong financial management capabilities, investments in new product lines could destroy corporate profitability instead of developing it. Therefore, these problems must be addressed first.

II.2      Hurdle Rates

In simple understanding, hurdle rate means the minimum acceptable rate of return on a capital investment project. It is required to measure the limitation of when an investment is no longer considered profitable. The calculation has the basic logic of requiring returns to be higher than the cost of investment. However it also incorporate several factors such as the cost of risk, inflation, etc. It is a comprehensive look on how an investment will increase the wealth of the shareholders. Mathematically, the hurdle rate consists of the cost of the capital plus the project’s risk premium (‘The Hurdle Rate, 2006).

II.2.1   Corporate Hurdle Rates

The company seemed lacked logical reasoning to determine its hurdle rate. Corporate hurdle rate is based only by an experience on previous return of equity. According to the elaboration above, this policy is vulnerable to risks and provides low assurance for profit. The company must determine a new and more reasonable hurdle rate by incorporating factors such as cost of capital and risk premium (‘The Hurdle Rate’, 2006)

II.2.2   Cost of Capital

The cost of capital must be included within an investment calculation simply because we do not want to invest where we it provides us with no profit what so ever. Nevertheless, because obtaining money results additional costs, the concept cost of capital must include two things: the project cost and the financing cost. To be acceptable, a project must have a rate of return that exceeds the project cost plus the financing cost (‘The Hurdle Rate’, 2006)

II.2.3   Risk Premium

Nevertheless, cost of capital itself still does not provide a logical measurement toward a good financing decision. This is because every return from different sets of investment has a different degree of assurance. If the investment has less than 100% assurance for the return, then a risk premium must be included in the calculation of financing decision. However, the rate of risk premium must be set very in a very careful manner. Inadequate amount of risk premium will put our investment if jeopardy, on the other hand, over assuming the amount of risk premium will eliminate some profitable projects from consideration (‘The Hurdle Rate, 2006).

II.3      Financing Alternatives and Inflation

II.3.1   Corporate Financing Strategy

As mentioned in the case study, the company ha a unique strategy of financing. The company depends on equity financing methods a lot more than debt financing methods. On other words, the company survived through its years mostly by selling corporate equities. According to the case study, this is possible because the company has a remarkable reputation as a premium producer of household appliances and able to maintain good relationship with its affiliates.

Nevertheless, Arthur Foster, the financial president of the company seemed confuse about corporate unwillingness to use debt instruments. Debt instruments have a considerably lower cost than equity, especially after incorporating tax into the calculation. The company might want to reconsider its policies of financing instruments. Furthermore, he argues that a proper additional margin must also be incorporated into the calculation to offset the effect of inflation.

II.3.2   Debt and Equity Instruments

The company prefers the equity financing because it has lower cost and smaller legal risk. However, due to corporate policy of increasing dividend rate, the alternative is no longer providing more efficiency compare to debt instruments. Generally, debt instruments will result a slightly higher capital cost and they would require monthly payment, nevertheless, they do not have the risk of loosing corporate control to shareholders. Moreover, if the company is able to maintain the good credibility toward creditors, after some time they would be more than happy to facilitate the company with debt extensions.

On the other hand, the equity instruments are a tool of obtaining additional funds through affiliates or partners. These means management will loose more of the corporate control as the equity instruments build sups inside the company. Generally, the best option is to keep the proper balance between debt and equity financing instruments. Because the good balance differs among industry, the Star Appliance Company must put some effort in finding its own financing balance (‘Financing’, 2006).

II.3.3   Inflation

As stated by many economists in the late 1970’s, inflation was a significant factor influencing the cost of capital. A study by Cohen (1997) however, revealed that until today, inflation is still a significant influence for cost of capital. Inflation, even at its low rates, increases the user cost of capital significantly. If the rate of inflation decreases, the marginal gain in investment is greater compare to the rate of the decrease. This reflects the stronger effect of inflation toward cost of capital. Therefore, inflation should be incorporated in every investment analysis.

II.4.     Risk, Legal Fees and margin of Error

The last of Foster’s concerns is about how the company accounts for investment risks that are significantly larger than the others. There are opinions that riskier information should be evaluated using higher hurdle rates. Furthermore, Foster believed that there should be a margin to account for the existence of legal fees such as safety, and environmental costs. This margin is required to prevent the additional costs to eat away corporate profit from the investment. Finally, the investments must also calculate a margin of error, in order to account for unexpected disturbance in the forecasting process.

In case of using different hurdle rates for different projects, management theories favor the opposite. According to several management theories, investment and financing consideration has different factors that must not be brought together. Investment decisions are based on the consideration of which project are the most profitable, while financing decisions should focus on supporting investment decision and not altering it.

III.              Star Company Cost of Equity

Cost of Equity is measured by various indicators. However, one of the most utilized is the Weighted Average Cost of Capital ratio. A firm’s WACC is the overall required return on the firm as a whole. In simple terms, the ratio accounts for every possibility of financing a corporation. According to the WACC concept, a corporation can either be financed by debt, preferen stock or common stock. The WACC put all of these factors into equation that resulted the average interest the company must pay for every dollar it finances. The calculation is as follows:

WACC = w1k1(1-T) + w2k2 + w3k3

W1        = percentage of debt

K1         = the rate of interest

W2        = percentage of preferen stock

K2         = cost of preferen stock

W3        = percentage of common equity

K3         = cost of common equity

(Weston & Brigham, 1996)

According to existing data, the company financed most of its investments using retained earnings. The company did not have any long-term debt, which means that the w1 and k1 equals to 0. The case study also reveals that the company did not have any preferred stock within corporate balances sheet, which mean that the w2 and k2 equals to 0. Thus, the only variable exist within Star Appliance Company’s WACC is the common stock variable. Without the presence of debt and preferred stock, If we calculate the number of dividend paid and divide the result with total common stock of the company, then we will obtain a very high number of WACC.

 

Calculation :

WACC (1978)                        = percentage of common stock * (dividend paid/ total value of common stock)

WACC (1978)                        = 100% * [(dividend/share * total shares common stock)/total value of common stock]

WACC (1978)                        = 100% * [(1.52 * 13,414,268)/ 27,835,000]

WACC (1978)                        = 73%

 

The number means that on the period that ended December 31, 1978, the company paid as much as 73% for equity financing instruments. This is due to corporate operation to increase the rate of dividend paid, in order to satisfy shareholders. Despite corporate ability to sustain corporate operations and investment activities, the number is extremely high. Observing corporate financial structure, the company could easily obtain additional funding from debt instruments. Debts would have a much lower capital cost compare to the ‘sky-reaching’ dividend rate.

 

IV.              Recommendation

From the case study, we are able to capture two main problems of the Star Appliance Company. The first point is the problem of choosing from alternatives financing instrument. Arthur Foster believed that despite the acceptable state of corporate financial performance at the time, the company could be a lot more efficient by altering its financing strategy. The second issue is that of choosing between different methods of evaluating alternative investments. There are several alternatives of solution forth both problems.

 

IV.1     Choosing Financing Instruments

The first choice is to maintain corporate policy of using retained earnings and equity instruments in financing. This alternative will not create a problem for the company in the short-run. However, in the long-run, the company would need to expand its business by performing investment activities that require large amount of funds. This condition has been described in the case study as the company is trying to finance three projects with existing resource. In order to move forward with this project, the company needs to increase the efficiency of its financial structure. Maintaining current financing strategy will deny the company from further profitable investments using the projects.

The second choice is to use debt instruments to cover the needs for investment. This alternative could provide the company with large amount of funds, considering the company did not yet have a balance of long-term debt. However, debt instruments are known for its slightly higher cost compare to standard equity instrument’s cost. It also requires a monthly payment that could be a burden if occurred in large proportions. Furthermore, companies overburdened with debts generally less favored by shareholders and future investors.

The third alternative is to maintain a balance between debt and equity financing. This can be achieved by observing the debt-to-equity ratio and maintaining it within the proper balance. Some companies believe that a good company would not have a debt-to-equity ratio of more than 3 to 1. However, a good balance for debt-to-equity financing differs within each industry and the company must benchmark to other sin the industry to find the right balance.

 

IV.2    Methods of Choosing Investment Projects

Within this issue, foster emphasizes several important points: methods of determining the proper hurdle rate, incorporating inflation, incorporating legal cost and a margin of error. The first alternative is to remain practicing existing investment evaluation method: using 10% hurdle rate, with little consideration of inflation cost, legal cost and a margin of error. This method will result all three projects to be acceptable alternatives. The company might be able to successfully financed all three projects if it apply for further external financing instruments, however,  the level of accuracy within the calculation will be low and there will be no certainty of the real cash flow that will be received in following years.

The second alternative would be to incorporate financing costs, risk premium, inflation, legal cost and a margin of error. There is no sufficient data to perform these types of calculation within this paper. However, it can be estimated that the second alternative will not be acceptable according to the new hurdle rate and the new evaluation standard.

The third alternative is to incorporate financing costs, risk premium, inflation, legal cost, margin of error and additional margin for riskier investments that require additional asset. This alternative will present a more accurate calculation of existing projects, but it will influence investment decisions with consideration of financing, something that will reduce investment activities considerably.

 

V.                Solution

In choosing financing alternatives, the best solution for Star Appliance Company is to start using considerable debt instrument. The target is to balance the proportion between debt and equity. The company should have no difficulties in obtaining additional funds from debt instruments because of its good reputation and zero balance of long term debt. The balanced proportion between debt and equity instruments will lead to efficient financial management and resulted optimum capacity for further investment activities.

In designing methods of evaluating investment projects, the company should choose to incorporate inflation, legal fees and margin of error, but should not choose to make additional margins for relatively riskier projects. Each project should be calculated using similar percentage of hurdle rate plus additional costs mentioned previously.

 

VI.              Conclusion

Unlike most companies, the company seemed to have no problem in marketing and selling its premium product. However, the premium profits caused management to neglect efficiency concerns in managing its operations and investment decisions. The problem became visible as the company appointed new financial officer and tried to plan for further investment. Despite previous success, company’s WACC displayed that corporate cost of capital is significantly higher than average.

The new financial officer mentioned problems such as the lack consideration of inflation, legal fees and margin of error in evaluating new projects. These factors are important in providing managers with accurate investment decisions and accurate predictions of cash flow. For example, according to a study by Cohen (1997) inflation has a significant effect in cost of capital. Furthermore, not incorporating legal fees and margin of error will eat away the profit of the investment.

The solution presented for the company is to redesign its financing strategy into a balanced proportion between debt and equity. In terms of evaluating investment activities, the company should incorporate additional fees and a margin of error.