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CASE 17 Galaxy Systems, Inc. As the three division managers of When she discussed this approach Galaxy systems, Inc. entered the central with Joe Halstead, the CEO of Galaxy headquarters meeting room each felt Systems, he said the risk-adjusted under pressure. They were there to meet discount rate made a lot of sense to him. with Marlene Davidson, the senior vice He went on to say that management as president of finance. well as stockholders tend to be risk averse Marlene, a CPA who had spent seven and, therefore, higher risk projects should years with Ernst and Young before being meet tougher return standards. recruited by Galaxy Systems, was a strong However, in the case of Galaxy believer in implementing the latest techniques Systems, Mr. Halstead suggested they in corporate financial management. consider a slightly different approach. He She maintained that there should not be maintained that his company was made up one figure for cost of capital that was of three distinctly different businesses and uniformly applied throughout the that each business should have its own corporation. Although the current figure of imputed rate to be used as its discount rate. 12 percent was well documented, she The three divisions were a) the airline intended to propose that different types of investments utilize different discount rates. parts manufacturing division; b) the auto Her first inclination was to suggest that the airbags production division, and c) the aerospace division. The latter division built nature of the project be the controlling modern missile and control systems and jet factor in determining the discount rate. The fighter planes under contract with the riskier the project the higher the discount defense department of the U.S. government. rate required. For example, repair to old Mr. Halstead maintained that each machinery might carry a discount rate of six division had a risk dimension that was percent; a new product, 12 percent; and uniquely its own. He asked Marlene investments in foreign markets, 20 percent. Davidson about a strategy to measure risk This was a well accepted method that she exposure for each division. She suggested had used a number of times while on that there were two major approaches to consulting assignments at Ernst and Young. do this.A. Find comparable public companies in each industry the 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 high average betas would 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 division's annual earnings relative to the company's 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 Davidson 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 Ratheon, 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 California and the state had tough environmental laws. About one out of every five investments in his division were mandatory under California 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, while the other two divisions split the remainder of sales and income almost evenly.The Initial Decision After receiving the input from her boss and the three division heads, Marlene Davidson 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 .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 Davidson justified the high hurdle rate on the basis of an average beta of 1.35 in the aerospace industry and the highly risky business of dealing with the government. Contracts were often cut back when a new administration came into power. 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 $2,355,600 to develop. The anticipated revenue stream for the next 10 years was $400,000 per year. Proposal B The aerospace division proposed the development of new radar surveillance equipment. The anticipated cost was $2,441,700. The anticipated revenue stream for this project was $450,000 per year for the next 10 years. Proposal C Proposal C was a second proposal from the auto airbags 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 $145,680 and was expected to provide cost savings of $15,000 per year for 15 years.Proposal D Proposal D was a second proposal from the aerospace division. It called for the development of a new form of a microelectric 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 microelectric control system was $1,262,100 and the best guess estimate was that the investment would return $300,000 a year for the next eight years. Required 1. Compute the internal rate of return and the net present value for each of these four proposals. 2. Based strictly on the calculations, which proposals should be accepted or rejected. Use the appropriate divisional discount rate. The net present value provides the answer directly while the internal rate of return must be compared to the discount rate (which is the same as the required rate of return). 3. What subjective elements might override or influence any of the answers provided to Question 2. 4. 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 $2,441,700). He suggests that this might influence your decision. What should be your response