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 evaluating94 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 forCase 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 $396,00096 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