Galaxy Systems Inc.

As the three division managers of Galaxy Systems Inc. entered the central headquarters meeting room, each felt under pressure. They were there to meet with Marlene Davidson, the senior vice-president of finance. Marlene, a CA who had spent seven years with KPMG before being recruited by Galaxy Systems, was a strong believer in implementing the latest techniques in corporate financial management.

She maintained that there should not be one figure for cost of capital that was uniformly applied throughout the corporation. Although the current figure of 12 percent was well documented, she intended to propose that different types of investments utilize different discount rates. Her first inclination was to suggest that the nature of the project be the controlling factor in determining the discount rate. The riskier the project, the higher the discount rate required. For example, repair to old machinery might carry a discount rate of 6 percent; a new product, 12 percent; and investments in foreign markets, 20 percent. This was a well accepted method that she had used a number of times while on consulting assignments at KPMG.

When she discussed this approach with Joe Halstead, the CEO of Galaxy Systems, he said the risk-adjusted discount rate made a lot of sense to him. He went on to say that management as well as shareholders tended to be risk-averse, and therefore, higher-risk projects should meet tougher return standards.

However, in the case of Galaxy Systems, Joe suggested they consider a slightly different approach. He maintained that his company was made up of three distinctly different businesses and that each business should have its own imputed rate to be used as its discount rate. The three divisions were (1) the airline parts manufacturing division, (2) the auto airbags production division, and (3) the aerospace division. The latter division built modern missile and control systems and jet fighter planes under contract with the U.S. Defense Department.

Joe maintained that each division had a risk dimension that was uniquely its own. He asked Marlene about a strategy to measure risk exposure for each division. She suggested that there were two major approaches to do this.

A. Find comparable public companies in the industry each division was in and look up their betas. The higher the average beta for a given industry, the more risk the comparable companies in that industry had. Divisions that were in industries with higher average betas have higher required rates of return.

B. A second approach would not rely on betas for comparable companies to the division, but rather would utilize internal data for that division. The more volatile the divisions annual earnings were, relative to the companys annual earnings, the riskier the division and the higher the required rate of return.

The Meeting

CEO Joe Halstead liked these ideas and suggested that Marlene present them to the division managers. After the usual social patter following their arrival at central headquarters, Marlene laid her ideas on the table. At first, the division managers seemed somewhat shocked at her proposals. Marlene had not realized the extent that empire building had developed over the years. The three division managers clearly were apprehensive about what discount rate (sometimes referred to as a hurdle rate) would be assigned to their divisions.

The head of the airline parts manufacturing division argued against the use of the betas of publicly traded companies to determine risk. He said there were very few companies that were exclusively engaged in the manufacturing of airline parts. Most of his competitors were subsidiaries of other large companies such as McDonnell Douglas or Raytheon, which were involved in numerous activities. He argued that using the betas of such multi-industry firms and applying them to his division to determine risk would be unfair.

The head of the auto airbags production division had another concern. His three plants were all located in Ontario, and the province had tough environmental laws. About one out of every five investments in his division was mandatory under provincial law. Finally, the head of the aerospace division said that risk should not be the key variable for determining the divisional discount rates. He suggested that the key consideration in determining the discount rate should be the perceived importance of the division to the corporation. He said, Galaxy Systems was founded as an aerospace company and our future should be tied to our heritage. Approximately 40 percent of Galaxy Systems revenues and earnings were currently tied to the aerospace division, and the other two divisions split the remainder of sales and income almost evenly (30/30).

The Initial Decision

After receiving the input from her boss and the three division heads, Marlene decided to go with the following system. The weighted average cost of capital of 12 percent for the entire corporation would be the starting point for the corporation The airline parts manufacturing division would continue to use 12 percent as its discount rate.

Because firms comparable to the auto airbags production division had an average beta of 0.8 and the division itself had less-variable earnings from year to year than the corporation, it would be assigned a discount rate of 10 percent.

The head of the aerospace division was displeased to be assigned a discount rate of 15 percent. Marlene justified the high hurdle rate on the basis of an average beta of 1.55 in the aerospace industry and the highly risky business of dealing with various governments. Contracts were based on politics. a hard risk to quantify.

The risk-free rate of return was currently 6 percent and the expected premium for market risk was 5.5 percent.

The CCA rate on all equipment required for the capital investments is 20 percent. The firms tax rate is 40 percent.

Application of Divisional Hurdle Rates

The application of the new system got its first test when the auto airbags production division and the aerospace division simultaneously submitted four proposals.

Proposal A: The auto airbags production division submitted a proposal for a new airbag model that would cost $3,050,000 to develop. The anticipated revenue stream for the next 10 years was $720,000 per year.

Proposal B. The aerospace division proposed the development of new radar surveillance equipment. The anticipated cost was $3,100,000. The anticipated revenue stream for this project was $750,000 per year for the next 10 years.

Proposal C. This was a second proposal from the auto airbags production division. It called for special equipment to be used in the disposal of environmentally harmful waste material created in the manufacturing process. The equipment cost $225,000 and was expected to provide cost savings of $30,000 per year for 15 years.

Proposal D. This was a second proposal from the aerospace division. It called for the development of a new form of a micro electric control system that could be used for fighter jets that were still in the design stage at another aerospace company. If the other aerospace company was successful in the development of the fighter jets, they would be sold to underdeveloped countries in various sectors of the world. The cost to produce the micro electric control system was $1,700,000 and the best-guess estimate was that the investment would return $500,000 a year for the next eight years.

a. Which proposals should be accepted or rejected? Use an appropriate divisional discount rate. Do you agree with the discount rates assigned by Marlene Davidson?

b. What subjective elements might override or influence any of the answers determined by quantitative analysis?

c. Assume the head of the aerospace division asked for a second review on the new radar surveillance equipment (proposal B). He maintains that the numbers presented in proposal B are correct, but he wants you, the analyst, to know that $300,000 has already been spent on the initial research on this project. (It's not included in the 3,100,000.) He suggests that this might influence your decision. What should be your response?