20 Divisional Costs of Capital We Are Not All Alike! Pamela Sanderson was at it again! It seemed like she made waves wherever she went. At her...
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How would I frame the problems in financial theory

What is financial theory?

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20
Divisional Costs of Capital
We Are Not All Alike!
Pamela Sanderson was at it again! It seemed like she made waves
wherever she went. At her previous job, which incidentally was also with
a Fortune 500 company, Pamela had successfully implemented a system
of evaluating projects based on differential (risk-adjusted) hurdle rates.
However, the change caused so much uproar and unpleasantness among
divisional heads that Pamela knew her days at the job were numbered.
Eventually she quit and given her sound credentials had no trouble
finding another job.
At her current job as Vice President of Finance for Southern
Modular Systems, Pamela had to evaluate proposals that came in for
funding from the firm's three product divisions; Defense, Consumer
Products, and Industrial Supply, During her very first month at the job.
she was presented with three funding requests, one from each department
(see Table 1 for project cost and cash flow projections). Being unclear as
to what the policy was regarding the hurdle rate to be used in evaluating

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94
Case 20
We Are Not All Alike!
12.48%
12.48%
such projects. Pamela decided to calculate the company's weighted
average cost of capital herself. After carefully analyzing the firm's
financial statements and talking to the underwriters, Pamela estimated
that the firm's weighted average cost of capital was around (14%) When
she consulted with her boss, Marty Puchala, she was pleased to learn that
the firm had been using 14% recently as the hurdle rate for all project
evaluations. What troubled her was the fact that like her previous
employer, these folks too were not using differential hurdle rates for the
three different divisions. "Here we go again," thought Pamela. "I should
have asked about this at the interview. Oh well! I guess it's too late now.
I've got to do what I've got to do!"
Southern Modular Systems Inc., based in Charlotte, NC.
employed 5200 people at its various corporate and manufacturing
facilities. Its three divisions, Defense, Consumer Products, and Industrial
Supply, were organized on the basis of the type of products manufactured
and the clientele served. The Defense Division accounted for around 55%
of the sales volume, while the other two divisions split the balance. The
company manufactured and supplied high quality storage units made
from aluminum, plastic, and wood. During the past few years the Defense
division had done extremely well and was bringing in the majority of the
firm's profits. However, as is typical of most defense contractors, there
had been significant volatility in its sales and earnings figures over the
past eight years. The Consumer Products and Industrial Supply divisions
had been far less volatile but their profit margins had been lower. Overall
though, the firm was fairly well diversified and its beta had been
estimated at 1.1.
Pamela decided that she had better figure out a more logical
method of adjusting the divisional hurdle rates, because she strongly
believed that failure to do so would result in the firm making unwise
capital budgeting decisions. Given her training and philosophy there was
no way she was going to allow projects to be evaluated without due
consideration being given to their respective volatilities. "We are not all
alike." she said to her boss. Marty. "and we should not pretend to be.
Don't you agree?" To her good luck, Marty agreed. So Pamela went to
work.
The first thing she did was refer back to her notes from graduate
school (they do come in handy sometimes, you know) and remembered
that there were two ways she could go about doing the adjustment for

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Case 20 We Are Not All Alike!
95
differences in risk across corporate divisions. One way was to measure or
collect the equity betas of comparable homogeneous companies and
substitute those in place of the firm's overall beta when calculating the
weighted average cost of capital. The other way was to simply adjust the
firm's weighted average cost of capital up or down based on the relative
variability of each division's sales and/or earnings. After doing some
research on the Internet, Pamela decided against the first option because
most of the firm's competitors were involved in multiple industry sectors.
Accordingly, she decided to go ahead with the second alternative and
requested the accounting department to provide her with quarterly sales
data for the prior eight years broken down by divisions (Table 2). She
decided to calculate the relative variability of each division's revenues
with respect to that of the overall firm and accordingly adjust the firm's
hurdle rate when evaluating proposals submitted by each department.
After doing some quick calculations, Pamela sent off emails to
the Vice-Presidents of the three divisions setting up a time for a meeting.
Somehow, Pamela knew that it was not going to be a pleasant meeting.
Table I
Projected Costs, Lives, and Cash inflows of Divisional Proposals
Annual Net Cash
Division
Cost
Life
Flow
Defense
$ (1,400,000)
5
$400,000
Consumer Products
$ (1,600,000)
6
$390,000
Industrial Supply
$ (1,800,000) 7
$396,000

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96
Case 20
We Are Not All Alike!
Table 2
Divisional Breakdown of Quarterly Revenues
---Quarterly Revenues...
Defense Consumer Industrial
Quarter
Products
Products Products Consolidated
2,800,000
1,725,000
1.620,000
6,145,000
GREGORNOUAWN
2,940,000
1,776,750
1,668,600
6,385,350
3,087,000
1,830,053
1,718,658
6,635,711
3,241,350
1,884.954
1,770,218
6,896,522
3,403,418
1,941,503
1,823.324
7.168,244
3,573,588
1,999,748
1,878,024
7.451,360
3,680,796
2.059,740
1,934,365
7.674,901
3,791.220
2.121,532
1.992,396
7,905.148
3.904.957
2,185,178
2.052,168
8,142,302
4,022,105
2,250,734
2.113,733
8,386.571
4.142,768
2,318,256 2,177,145
8,638,169
4,267,051
2,387,803
2.242,459
8,897,314
4.395,063
2.459.438
2,309,733
9, 164,233
14
4,526,915
2,533,221
2,379.025
9,439,160
15
4,662.722
2,609,217
2,450.395
9.722,335
16
4.429.586
2.687,494
2,523,907
9.640,987
17
4.695.361
2.768, 119
2.599,624 10,063,104
18
4,883,176
2.851, 162
2.677,613 10,411,951
19
5,078,503
2.936,697
2,757,942 10,773,141
20
5,281,643
3,024.798
2,840,680 11,147,121
21
5,492,909
3,115,542
2,925,900 11,534,351
22
5,712,625
3,209.008
3,013.677 11,935.310
23
5,941,130
3,305,278
3,104.088 12.350.496
24
6,178,775
3,404.437
3,197,210 12,780.422
25
6,487.714
3,506,570
3,325,099 13,319,382
26
6.812.100
3.611,767
3,424,852 13,848,718
27
7.152.705
3,720,120
3,527,597 14,400,422
28
7.510.340
3.831,724
3,668,701 15,010,764
29
7,885,857
3.946,675
3,778,762 15,611,294
30
8,280,150
4,065,075
3,892,125 16,237,350
31
8,694,157
4.187.028
4,008,889 16,890,074
32
9,400,000
4,300.000
4,125,000 17,825,000
D
X

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