Questions:

i. Rank the projects on the basis of the measurements discussed above.

ii. Was Smith correct in stating that all of the measurements necessarily would result in the same ranking order? Why? Explain?

iii. Given the limited funds the Company had generated in 2002 which set of projects should EDO accept in year 2003?

iv. Given the capital rationing, rank the combination of the projects on the basis of any investment criteria you feel is important. Which set of projects provides the highest value to the Company?

EDO CORPORATION On January 2, 2003, in the strategic committee meeting of the company, James Smith Chairman, President and Chief Executive Officer said, we are optimistic about 2003 and the years beyond. The proposed projects presently under consideration will enable us efficiently to expand our productivity in order to meet ever-increasing customers demand with high quality engineered products and systems for defense, aerospace and industrial applications. Our greatest strength lies in the fact that we have assembled, throughout our company, motivated and dedicated employees with the necessary knowledge and skills to produce well in our highly competitive environment. We will continue to invest in our company and people who will make customer-oriented products, because, they are the all-important ingredient in EDO's success. EDO Corporation is a supplier of sophisticated, highly engineered products and systems for defense, aerospace and industrial applications. The Company has three equally size business divisions. 1. Defense Division The Company's Defense division provides integrated front-line war-fighting systems and components, including electronic warfare systems, reconnaissance and surveillance systems, aircraft weapons suspension and release systems and airborne mine countermeasures systems. 2. Communications-Space Division The Company's Communications -Space division supplies antenna products and ultra-miniature electronics and systems for the remote sensing, communications and electronic warfare industries. 3. Engineered Materials Division The Company's Engineered Materials division supplies piezoelectric ceramic products for commercial and military markets and advanced fiber composite structural products for the aircraft, communication, navigation, chemical, petrochemical, paper, and oil industries. Financial Information The company had total sales of $329 million with net income of $14 million in 2002. The Company posted a one-year sales growth of 43.9% with net profit margin of 3.1%. The company has maintained a constant dividend policy of $0.12 per share and its stock price traded for $25.01 at end of 2002. Tables 1-2 provide the financial information. The Company retired its preferred stock in year 2000 but issued $137.8 million in new debt in 2002. The debt is a 5.25% convertible subordinated note due 2007 with a par value of $1,000. The convertible bonds could be refinanced at the prevailing market interest rate. Finance Committee and Capital Budgeting Process The capital budgeting process at EDO was centralized and each division was responsible for its own project development with the final approval of capital expenditures by the Finance Committee of the Company. Accordingly, each division submitted the following independent projects to the Finance Committee for consideration: 1. Engineered Materials Division Project Initial Cost Annual Net Cash Flows Expected Life $1,500,000 $592,582 E2 $2,000,000 $541,141 $2,000,000 $528,474 E4 $1,000,000 $329,234 Total $6,500,000 Average life 4.5 E1 E3 + Expected Life 2.Defense Division Project Initial Cost D1 $1,000,000 D2 $1,000,000 $1,000,000 D4 $2,000,000 D5 $2,000,000 Total $7,000,000 D3 Annual Net Cash Flows $219,120 $319,775 $222,851 $368,580 $542,784 Average life Expected Life 3. Communications-Space Division Project Initial Cost Annual Net Cash Flows $1,000,000 $229,607 C2 $1,000,000 $284,315 C3 $1,500,000 $356,535 $1,000,000 $233,192 $2,000,000 $757,982 Total $6,500,000 Average life The Finance Committee consisted of James Smith Chairman, President and Chief Executive Officer, Fran Otto Executive Vice President, Jon Anderson Vice President for Marketing, and Frederic Bassett Vice President of Finance with his two associates, Janet Johnson, Controller and Patricia Otis, MBA and CFA, Director of Investor Relations. Each member of the Committee was expected to come to the meeting prepared to discuss the merit of each project and the criteria that should be used to select each project. In their meeting to consider the projects a debate ensued on the most appropriate capital budgeting criteria. Smith indicated that he has evaluated the merit of each project and suggested the use of NPV. Frederic Bassett suggested that, perhaps we should use relative profitability or some measure of expected rate of return criteria because the Company did not have enough income to undertake all of the projects. Janet Johnson agreed with Bassett, and recommended the profitability index (PI). She argued that the profitability index would provide a benefit-cost ratio which would take relative size of each outlay into consideration by ranking the project according to their added value to the Company. Patricia Otis, a recent MBA graduate and Chartered Financial Analyst (CFA), agreed with both of them, however, she suggested that the use of internal rate of return would also provide a measure of relative profitability and would also take into consideration the relative size of each investment in the ranking process. To resolve the issue, Smith stated that the projects could be evaluated by all three measures, since they would undoubtedly result in the same ranking if we use the company's cost of capital. The Divisional Hurdle Rate and the Capital Asset Pricing Model The Finance Committee disagreed with Smith and contended that the Defense division was riskier than Communications- Space and Engineered Materials divisions, and argued that the current practice of capital budgeting did not formally incorporate risk in the analysis and as a result, the ranking would be inappropriate. Specifically, the lack of risk consideration is more evident in the Communications-Space and Engineered Materials divisions, since the Communication- Space is less risky than Engineered Materials. However, their productions, earnings, and profits are highly correlated and fluctuate with the economy. As a result, both divisions provide a very stable income to the Company. On the other hand, the Defense division provides military products and professional services to the United States, allied governments, and their prime defense contractors, and as a result, the earnings and profits of the Defense division tended to be tied to the world geo-political environment. Janet Johnson and Patricia Otis suggested that the risk characteristic of each project could be considered and a risk-adjusted discount rate for each division to be estimated. Bassett argued that it would be difficult to develop risk-adjusted hurdle rates for each division. Estimation of the hurdle rates for each division would involve collection of the enormous data. Both Johnson and Otis agreed with Bassett and they felt that with different project risk and divisional cost of capital, the ranking would be different. They indicated that one way of estimating divisional cost of capital was to calculate the risk-adjusted discount rate for each division by using capital asset pricing model (CAPM). When they were asked about the CAPM, they replied: The process of CAPM involves a conceptual framework for estimating the systematic risk and hence the risk-adjusted discount rate of each division based on its beta coefficient which is a measure of the sensitivity of division's return to market fluctuations. This process allows each project to be discounted at a rate commensurate with its own risk. However, Jon Anderson and Fran Otto were not impressed by the concept of the divisional cost of capital. Specifically, they questioned, how the divisional cost of capital could be calculated when there were no separate financial information for each division. They stated that the capital asset pricing model builds on the risk-premium approach, which takes into account the risk of each division in question. It uses the stock's beta (the covariance of the stock's rate of return with average rate of return of a market index) of the publically traded companies as a measure of risk which might be representative of the divisional risk. Patricia Otis tells the Committee that she recalls from one of her MBA classes that a suggested method was called pure play, identifying companies that are in the same industry or similar to the division. Anderson suggested that the Committee could use the corporate cost of capital for all of the projects. He stated that, the Company currently uses a 12 percent cost of capital based on the past capital structure for funds generated internally, and he did not see any reason to depart from this figure. Even, he suggested that the Company can estimate a new corporate cost of capital to reflect the new risk of the projects. Feeling somewhat frustrated, Johnson and Otis disagreed with Anderson by stating that a properly applied multiple-discount rate would ensure that EDO would remain competitive by allocating limited funds to the three divisions with their varying degrees of risk. They also argue that by using Company's past overall cost of capital to each division might result in acceptance/ rejection of unprofitable/profitable projects. They stated that more and more companies were using divisional cost of capital for their resource allocations, and it would not be difficult to calculate a new corporate and divisional hurdle rate for EDO. They indicated that the divisional cost of capital could be estimated by considering each division as a stand-alone company and comparing them to those publicly traded companies that were most like them and using their betas as proxies. Table 3 provides information about publicly traded companies and their industries. Suggested Questions: 1. Discuss the strengths and weakness of each measures of investment presented in the case. Will all of the measures rank the projects identically? Why or why not? 2. Rank the projects on the basis of the measurements discussed above. 3. Was Smith correct in stating that all of the measurements necessarily would result in the same ranking order? Why? Explain? 4. Given the limited funds the Company had generated in 2002 which set of projects should EDO accept in year 2003? Given the capital rationing, rank the combination of the projects on the basis of any investment criteria you feel is important. Which set of projects provides the highest value to the Company? Table 1 Annual Income Statement (Values in Millions) Sales Cost of Sales Gross Operating Profit Selling, General & Admin. Expense EBITDA Depreciation | EBIT Interest Expense Pre-tax Income Income Taxes 40% Net Income from Operations Total Common Shares Outstanding Dividends Paid per Share Preferred Dividends Earnings per Share Dec-98 $96.10 $65.40 $30.70 $18.80 $11.90 $4.60 $7.30 $2.30 $5.00 $2.00 $3.00 6.6 $0.11 $1.10 $0.45| Dec-99 Dec-00 1-Dec $97.90 $206.80 $260.00 $68.90 $142.10 $178.30 $29.00 $64.70 $81.70 $16.30 $34.60 $42.80 $12.70 $30.10 $38.90 $3.40 $9.40 $11.40 $9.30 $20.70 $27.50 $2.40 $4.30 $3.10 $6.90 $16.40 $24.40 $2.76 $6.56 $9.76 $4.14 $9.84 $14.64 6.8 13.6 19.8 $0.16 $0.21 $0.26 $1.00 $0.00 $0.00 $0.61 | $0.72| $0.74 2-Dec $328.90 $229.50 $99.40 $56.10 $43.30 $11.30 $32.00 $6.70 $25.30 $10.12 $15.18 19.739 $0.31 $0.00 $0.77 Table 2 Annual Balance Sheet (Values in Millions) Dec-98 Dec-98 Dec-99 2-Ded Dec-99 Dec-00 Dec-001-Dec 1-Dec 2-Dec Assets Current Assets Cash and Equivalents Receivables Inventories Other Current Assets $21.80 $39.90 $9.80 $15.00 $86.50 $13.80 $32.80 $12.20 $20.40 $79.30 $2.20 $69.00 $24.90 $22.60 $118.70 $57.80 $83.40 $22.90 $5.50 $169.70 $132.30 $100.60 $32.40 $33.80 $299.20 Total Current Assets Non-Current Assets Property, Plant & Equipment, Gross Accumulated Depreciation $37.30 $27.10 $10.20 $9.10 $53.60 $39.60 $14.00 $11.70 $14.60 $40.30 $126.80 $94.40 $36.90 $57.50 $14.70 $102.40 $40.10 $62.30 Property, Plant & Equipment, Net Intangibles $111.70 $47.20 $64.50 $73.20 $44.60 $182.30 $26.00 Other Non-Current Assets Total Non-Current Assets Total Assets $23.30 $95.50 $30.80 $116.00 $45.30 $124.50 $214.30 $285.60 $481.60 Liabilities & Shareholder's Equity Current Liabilities Accounts Payable $24.40 $44.10 $47.40 $19.10 Short Term Debt $6.80 $5.40 $0.50 $0.00 $23.10 $1.90 $19.20 $44.20 | Other Current Liabilities $14.50 $45.70 $31.70 $81.20 | $16.70 $64.60 $75.70 $94.80 Total Current Liabilities Non-Current liabilities Long Term Debt $37.00 Deferred Income Taxes $0.00 $34.60 $0.00 $5.50 $0.00 $38.30 $1.20 $27.80 $0.00 $0.00 $0.00 $46.60 $0.00 Other Non-Current Liabilities $6.00 $0.00 $137.80 $0.00 $80.70 $0.00 $218.50 $313.30 $43.00 $40.10 $67.30 $148.50 $46.60 $111.20 $88.70 $84.30 Minority Interest Total Non-Current Liabilities Total Liabilities Shareholder's Equity Preferred Stock Equity Common Stock Equity Total Equity Total Liabilities & Equity Common Shares $0.10 $0.10 $0.00 $0.00 $38.00 $40.10 $65.80 $174.50 $38.10 $40.20 $65.80 $174.50 $126.80 $124.50 $214.30 $285.70 6.6 Mil | 6.8 Mil 13.6 Mil 19.8 Mil 61,000.00 57,000.00 | 49,000.00 0 1.8 Mil 1.7 Mil 1.4 Mil 182,000.00 $0.00 $168.30 $168.30 $481.60 19.7 Mil Preferred Shares Treasury Shares 94,000.00 Table 3 Financial Information of Major Companies Long- Current Total Debt 60- month Beta 0.30 0.93 1.89 0.21 Total Debt/ Asset 0..64 0.05 1.38 1.73 0.41 1.08 0.05 0.61 0.51 0.4 Long- term Debt/ Equity 0.82 0 1.09 1.72 0.16 1.06 0.04 0.54 0.49 0.39 term Debt/ Asset 0.29 0 0.28 0.33 0.07 0.34 0.03 0.23 0.22 0.22 Current LT Debt (000's) $137.80 $0.00 $319.50 $795.50 $0.10 $487.50 $30.90 $230.90 $215.50 $212.40 $313.30 $42.00 $825.50 $799.60 $81.20 $495.90 $33.00 $256.60 $223.30 $214.70 Market Shares Capital Outstanding Million (000's) $493.67 19,739 $5,197.13 177,014 $4,164.03 117,628 $2,191.86 38.623 | $1,348.77 24,523 81.145.88 246.425 $787.78 66,479 $755.55 15.114 $732.58 | 26.805 $587.73 15,846 0.16 2 .46 1.61 0.41 0.11 0.48 0.68 3.64 0.5 0.53 0.58 0.4 0.71 | 0.07 0.21 0.24 0.17 | NS 0.63 0 0.2 0.08 0.01 NA*| 0.31 0 0.12 0.04 0 0.63 $279.60 $0.50 $22.70 $23.40 $0.20 $55.00 $246.80 $0.00 $18.60 So 20 $0.00 $54.90 $555.33 | 21,075 $272.26 3,205 $220.68 9,874 $100 675 506 $57.53 2,935 $44.77 6,498 0.33 0.02 0.12 0 0.08 0 0.06 0 $1.60 $0.00 $0.80 $0.00 $19.88 $8.83 6.670 | 1.762 Stock Price Dec. 02 EDO CORPORATION EDO 25.01 ROCKWELL COLLINS INC COL 29.36 EMBR EMPRS BRSL DE AERO ERJ 35.4 ALLIANT TECHSYSTEMS INC ATK 56.75 ENGINEERED SUPPORT SYS EASI 55 CAE INC CGT 14 .65 AEROFLEX INC ARXX 11.85 MOOG INC CL A | MOG.A 49.99 DRS TECHNOLOGIES DRS | 27.33 TRIUMPH GROUP INC T GI 37.09 Defense ESTERLINE TECHNOLOGY CP ESL 26.35 TASER INTERNATIONAL INC TASR | 84.95 DUCOMMUN INC DCO 22.35 ALLIED DEFENSE GROUP ADG 1 23.55 REINHOLD INDUSTRIES INC R NHDA 19.6 TRANSTECHNOLOGY CORP TT | 6.89 HI-SHEAR TECHNOLOGY CORP HSR 1 2.98 KREISLER MANUFACTURING KRSL 15 .01 Engineering AVIALL INC AVL | 15.6 CURTISS-WRIGHT CP CL CM CW | 44.92 SIMULA INC SMU 1 3.19 TODD SHIPYARDS CORP TOD 17.61 UNITED INDUSTRIAL CORP UIC | 17.97 SIFCO INDUSTRIES INC SIF | 3.95 VALPEY FISHER CORP VPF 1 3.03 Communications and Aerospace AAR CORP 15.3 BE AEROSPACE INC BEAV 5.71 HEXCEL CORP HXL 7.38 HEICO CORP HEI 16.64 PEMCO AVIATION GROUP INC PAGI 334 FAIRCHILD CORP A FA 5.13 CPI AEROSTRUCTURES INC CVU 11.6 AEROSONIC CORP AIM 8.72 HAWK CORP HWK 3.75 ORBITAL SCIENCES CORP ORB 12.18 FIRST AVIATION SRVCS INC FAVS 1 4 .14 ICTS INTERNATIONAL NV ICTS 3.1 SPACEHAB INC SPAB | 1.8 MERCURY AIR GROUP INC MAX 0.97 0.37 NS 0.34 0.29 NA* 0.12 0.15 0.59 1.08 0 1.05 0.16 0.54 0.78 1.53 0 $208.60 $223.60 $59.80 $0.00 $0.00 $10.50 $0.00 $204.80 $222.70 $0.20 $0.00 $0.00 $9.00 $0.00 $492.37 | 31,562 $536.66 | 11.947 $41.96 13,154 $93.40 5,304 $244.19 13,589 $20.35 5,152 $12.68 4,185 0 0.34 0.1 0 0.3 0 0.15 0 AIR 1.05 0.93 0.71 0.4 0.87 | 0.561 12.31 12.06 NS NA* 0.27 0.24 0.24 0.78 0 0.15 $220.80 $787.60 $487.30 $44.00 $174.70 $784.40 $484.60 $44.00 $487.26 $208.95 $285.76 $160.59 31.847 36,594 38,721 9,651 0.04 3.94 3.83 046 $2170 $2040 $135 00 | 4042 0 3 0.5 0.25 0.08 0.18 1.44 0.29 0.55 1.14 0.05 0.02 0.01 3.48 0 0.46 0.26 0.13 2.43 1.55 0.36 0.87 10.85 0.28 0.4 0.4 0.22 0.17 0 0 NS NA* 0.66 . 510411 0.11 $8.30 $0.00 $3.60 $93.60 $140.00 $14.50 $16.20 $80.90 $54.10 $4.30 $129.20 $0.00 $61.31 $0.00 $34.19 $68.70 $32.15 $138.10 $584.08 $14.50 $30.14 $5.90 $20.19 $77.50 $22.31 $50.001 $16.77 25.18 5,285 .921 8,574 47,954 7.281 ,513 12.397 3.289 6 0 1 LMI AEROSPACE INC LMIA 1.99 0.08 0.77 0.65 0.32 $29.30 $8.80 $16.28 8.182 | BB | Table 4 Key Industrial Financial Ratios (Three-year medians 2000-2002) Credit Rating | BBB Investment Grade Noninvestment Grade 13.3 22 1.0 65.7 19.7 33.6 EBIT interest coverage (x) Funds from operations/total debt (%) Free operating cash flow/total debt (%) Return on capital (%) Operating income/sales (%) Long-term debt/capital, book (%) Total debt/capital, book (%) 23.4 214.2 156.6 35.0 23.4 (1.1) 5.0 26.6 6.3 42.2 22.3 18.1 18.1 33.8 42.6 3.9 30.6 12.8 13.1 15.5 40.3 1 47.0 1 10.4 1.5 8.0 14.7 72.6 75.1 7.3 11.5 15.4 53.6 57.7 24.0 21.1 35.9 | | | + Table 5 Capital Market and Financial Information On or Around December 2002 Capital Market Conditions, 2002 U.S. Treasury Obligations Yield 3-mos. 6 mos. 1.670% 1.710% 2.310% 1 yr. 2 yr. 3 yr. 5 yr. 3.160% 3.660% 4.090% 4.520% 4.860% 5.650% 7 yr. 10 yr. 20 yr. Corporate Debt Obligations (5-year) AAA Yield 9.307% 9.786% 10.083% 10.894% 12.753% 14.663% BBB BB Other Instruments U.S. Federal Reserve Bank Discount Rate LIBOR (1-month) Certificates of Deposit (6-month) Yield 1.730% 1.840% 1.980% Prime Interest Rates 4.750% Sources of data: Bloomberg LP, Federal Reserve Bank Reports. Table 6-Historical Returns, 1926-2002 Standard Deviation Large Company Stocks Small Company Stocks Long-Term Corporate Bonds Long-Term Government Bonds U.S. Treasury Bills Average Annual Return 12.20% 16.90% 6.20% 5.80% 3.80% 3.10% 20.50% 33.2 8.7 9.4 Inflation EDO CORPORATION On January 2, 2003, in the strategic committee meeting of the company, James Smith Chairman, President and Chief Executive Officer said, we are optimistic about 2003 and the years beyond. The proposed projects presently under consideration will enable us efficiently to expand our productivity in order to meet ever-increasing customers demand with high quality engineered products and systems for defense, aerospace and industrial applications. Our greatest strength lies in the fact that we have assembled, throughout our company, motivated and dedicated employees with the necessary knowledge and skills to produce well in our highly competitive environment. We will continue to invest in our company and people who will make customer-oriented products, because, they are the all-important ingredient in EDO's success. EDO Corporation is a supplier of sophisticated, highly engineered products and systems for defense, aerospace and industrial applications. The Company has three equally size business divisions. 1. Defense Division The Company's Defense division provides integrated front-line war-fighting systems and components, including electronic warfare systems, reconnaissance and surveillance systems, aircraft weapons suspension and release systems and airborne mine countermeasures systems. 2. Communications-Space Division The Company's Communications -Space division supplies antenna products and ultra-miniature electronics and systems for the remote sensing, communications and electronic warfare industries. 3. Engineered Materials Division The Company's Engineered Materials division supplies piezoelectric ceramic products for commercial and military markets and advanced fiber composite structural products for the aircraft, communication, navigation, chemical, petrochemical, paper, and oil industries. Financial Information The company had total sales of $329 million with net income of $14 million in 2002. The Company posted a one-year sales growth of 43.9% with net profit margin of 3.1%. The company has maintained a constant dividend policy of $0.12 per share and its stock price traded for $25.01 at end of 2002. Tables 1-2 provide the financial information. The Company retired its preferred stock in year 2000 but issued $137.8 million in new debt in 2002. The debt is a 5.25% convertible subordinated note due 2007 with a par value of $1,000. The convertible bonds could be refinanced at the prevailing market interest rate. Finance Committee and Capital Budgeting Process The capital budgeting process at EDO was centralized and each division was responsible for its own project development with the final approval of capital expenditures by the Finance Committee of the Company. Accordingly, each division submitted the following independent projects to the Finance Committee for consideration: 1. Engineered Materials Division Project Initial Cost Annual Net Cash Flows Expected Life $1,500,000 $592,582 E2 $2,000,000 $541,141 $2,000,000 $528,474 E4 $1,000,000 $329,234 Total $6,500,000 Average life 4.5 E1 E3 + Expected Life 2.Defense Division Project Initial Cost D1 $1,000,000 D2 $1,000,000 $1,000,000 D4 $2,000,000 D5 $2,000,000 Total $7,000,000 D3 Annual Net Cash Flows $219,120 $319,775 $222,851 $368,580 $542,784 Average life Expected Life 3. Communications-Space Division Project Initial Cost Annual Net Cash Flows $1,000,000 $229,607 C2 $1,000,000 $284,315 C3 $1,500,000 $356,535 $1,000,000 $233,192 $2,000,000 $757,982 Total $6,500,000 Average life The Finance Committee consisted of James Smith Chairman, President and Chief Executive Officer, Fran Otto Executive Vice President, Jon Anderson Vice President for Marketing, and Frederic Bassett Vice President of Finance with his two associates, Janet Johnson, Controller and Patricia Otis, MBA and CFA, Director of Investor Relations. Each member of the Committee was expected to come to the meeting prepared to discuss the merit of each project and the criteria that should be used to select each project. In their meeting to consider the projects a debate ensued on the most appropriate capital budgeting criteria. Smith indicated that he has evaluated the merit of each project and suggested the use of NPV. Frederic Bassett suggested that, perhaps we should use relative profitability or some measure of expected rate of return criteria because the Company did not have enough income to undertake all of the projects. Janet Johnson agreed with Bassett, and recommended the profitability index (PI). She argued that the profitability index would provide a benefit-cost ratio which would take relative size of each outlay into consideration by ranking the project according to their added value to the Company. Patricia Otis, a recent MBA graduate and Chartered Financial Analyst (CFA), agreed with both of them, however, she suggested that the use of internal rate of return would also provide a measure of relative profitability and would also take into consideration the relative size of each investment in the ranking process. To resolve the issue, Smith stated that the projects could be evaluated by all three measures, since they would undoubtedly result in the same ranking if we use the company's cost of capital. The Divisional Hurdle Rate and the Capital Asset Pricing Model The Finance Committee disagreed with Smith and contended that the Defense division was riskier than Communications- Space and Engineered Materials divisions, and argued that the current practice of capital budgeting did not formally incorporate risk in the analysis and as a result, the ranking would be inappropriate. Specifically, the lack of risk consideration is more evident in the Communications-Space and Engineered Materials divisions, since the Communication- Space is less risky than Engineered Materials. However, their productions, earnings, and profits are highly correlated and fluctuate with the economy. As a result, both divisions provide a very stable income to the Company. On the other hand, the Defense division provides military products and professional services to the United States, allied governments, and their prime defense contractors, and as a result, the earnings and profits of the Defense division tended to be tied to the world geo-political environment. Janet Johnson and Patricia Otis suggested that the risk characteristic of each project could be considered and a risk-adjusted discount rate for each division to be estimated. Bassett argued that it would be difficult to develop risk-adjusted hurdle rates for each division. Estimation of the hurdle rates for each division would involve collection of the enormous data. Both Johnson and Otis agreed with Bassett and they felt that with different project risk and divisional cost of capital, the ranking would be different. They indicated that one way of estimating divisional cost of capital was to calculate the risk-adjusted discount rate for each division by using capital asset pricing model (CAPM). When they were asked about the CAPM, they replied: The process of CAPM involves a conceptual framework for estimating the systematic risk and hence the risk-adjusted discount rate of each division based on its beta coefficient which is a measure of the sensitivity of division's return to market fluctuations. This process allows each project to be discounted at a rate commensurate with its own risk. However, Jon Anderson and Fran Otto were not impressed by the concept of the divisional cost of capital. Specifically, they questioned, how the divisional cost of capital could be calculated when there were no separate financial information for each division. They stated that the capital asset pricing model builds on the risk-premium approach, which takes into account the risk of each division in question. It uses the stock's beta (the covariance of the stock's rate of return with average rate of return of a market index) of the publically traded companies as a measure of risk which might be representative of the divisional risk. Patricia Otis tells the Committee that she recalls from one of her MBA classes that a suggested method was called pure play, identifying companies that are in the same industry or similar to the division. Anderson suggested that the Committee could use the corporate cost of capital for all of the projects. He stated that, the Company currently uses a 12 percent cost of capital based on the past capital structure for funds generated internally, and he did not see any reason to depart from this figure. Even, he suggested that the Company can estimate a new corporate cost of capital to reflect the new risk of the projects. Feeling somewhat frustrated, Johnson and Otis disagreed with Anderson by stating that a properly applied multiple-discount rate would ensure that EDO would remain competitive by allocating limited funds to the three divisions with their varying degrees of risk. They also argue that by using Company's past overall cost of capital to each division might result in acceptance/ rejection of unprofitable/profitable projects. They stated that more and more companies were using divisional cost of capital for their resource allocations, and it would not be difficult to calculate a new corporate and divisional hurdle rate for EDO. They indicated that the divisional cost of capital could be estimated by considering each division as a stand-alone company and comparing them to those publicly traded companies that were most like them and using their betas as proxies. Table 3 provides information about publicly traded companies and their industries. Suggested Questions: 1. Discuss the strengths and weakness of each measures of investment presented in the case. Will all of the measures rank the projects identically? Why or why not? 2. Rank the projects on the basis of the measurements discussed above. 3. Was Smith correct in stating that all of the measurements necessarily would result in the same ranking order? Why? Explain? 4. Given the limited funds the Company had generated in 2002 which set of projects should EDO accept in year 2003? Given the capital rationing, rank the combination of the projects on the basis of any investment criteria you feel is important. Which set of projects provides the highest value to the Company? Table 1 Annual Income Statement (Values in Millions) Sales Cost of Sales Gross Operating Profit Selling, General & Admin. Expense EBITDA Depreciation | EBIT Interest Expense Pre-tax Income Income Taxes 40% Net Income from Operations Total Common Shares Outstanding Dividends Paid per Share Preferred Dividends Earnings per Share Dec-98 $96.10 $65.40 $30.70 $18.80 $11.90 $4.60 $7.30 $2.30 $5.00 $2.00 $3.00 6.6 $0.11 $1.10 $0.45| Dec-99 Dec-00 1-Dec $97.90 $206.80 $260.00 $68.90 $142.10 $178.30 $29.00 $64.70 $81.70 $16.30 $34.60 $42.80 $12.70 $30.10 $38.90 $3.40 $9.40 $11.40 $9.30 $20.70 $27.50 $2.40 $4.30 $3.10 $6.90 $16.40 $24.40 $2.76 $6.56 $9.76 $4.14 $9.84 $14.64 6.8 13.6 19.8 $0.16 $0.21 $0.26 $1.00 $0.00 $0.00 $0.61 | $0.72| $0.74 2-Dec $328.90 $229.50 $99.40 $56.10 $43.30 $11.30 $32.00 $6.70 $25.30 $10.12 $15.18 19.739 $0.31 $0.00 $0.77 Table 2 Annual Balance Sheet (Values in Millions) Dec-98 Dec-98 Dec-99 2-Ded Dec-99 Dec-00 Dec-001-Dec 1-Dec 2-Dec Assets Current Assets Cash and Equivalents Receivables Inventories Other Current Assets $21.80 $39.90 $9.80 $15.00 $86.50 $13.80 $32.80 $12.20 $20.40 $79.30 $2.20 $69.00 $24.90 $22.60 $118.70 $57.80 $83.40 $22.90 $5.50 $169.70 $132.30 $100.60 $32.40 $33.80 $299.20 Total Current Assets Non-Current Assets Property, Plant & Equipment, Gross Accumulated Depreciation $37.30 $27.10 $10.20 $9.10 $53.60 $39.60 $14.00 $11.70 $14.60 $40.30 $126.80 $94.40 $36.90 $57.50 $14.70 $102.40 $40.10 $62.30 Property, Plant & Equipment, Net Intangibles $111.70 $47.20 $64.50 $73.20 $44.60 $182.30 $26.00 Other Non-Current Assets Total Non-Current Assets Total Assets $23.30 $95.50 $30.80 $116.00 $45.30 $124.50 $214.30 $285.60 $481.60 Liabilities & Shareholder's Equity Current Liabilities Accounts Payable $24.40 $44.10 $47.40 $19.10 Short Term Debt $6.80 $5.40 $0.50 $0.00 $23.10 $1.90 $19.20 $44.20 | Other Current Liabilities $14.50 $45.70 $31.70 $81.20 | $16.70 $64.60 $75.70 $94.80 Total Current Liabilities Non-Current liabilities Long Term Debt $37.00 Deferred Income Taxes $0.00 $34.60 $0.00 $5.50 $0.00 $38.30 $1.20 $27.80 $0.00 $0.00 $0.00 $46.60 $0.00 Other Non-Current Liabilities $6.00 $0.00 $137.80 $0.00 $80.70 $0.00 $218.50 $313.30 $43.00 $40.10 $67.30 $148.50 $46.60 $111.20 $88.70 $84.30 Minority Interest Total Non-Current Liabilities Total Liabilities Shareholder's Equity Preferred Stock Equity Common Stock Equity Total Equity Total Liabilities & Equity Common Shares $0.10 $0.10 $0.00 $0.00 $38.00 $40.10 $65.80 $174.50 $38.10 $40.20 $65.80 $174.50 $126.80 $124.50 $214.30 $285.70 6.6 Mil | 6.8 Mil 13.6 Mil 19.8 Mil 61,000.00 57,000.00 | 49,000.00 0 1.8 Mil 1.7 Mil 1.4 Mil 182,000.00 $0.00 $168.30 $168.30 $481.60 19.7 Mil Preferred Shares Treasury Shares 94,000.00 Table 3 Financial Information of Major Companies Long- Current Total Debt 60- month Beta 0.30 0.93 1.89 0.21 Total Debt/ Asset 0..64 0.05 1.38 1.73 0.41 1.08 0.05 0.61 0.51 0.4 Long- term Debt/ Equity 0.82 0 1.09 1.72 0.16 1.06 0.04 0.54 0.49 0.39 term Debt/ Asset 0.29 0 0.28 0.33 0.07 0.34 0.03 0.23 0.22 0.22 Current LT Debt (000's) $137.80 $0.00 $319.50 $795.50 $0.10 $487.50 $30.90 $230.90 $215.50 $212.40 $313.30 $42.00 $825.50 $799.60 $81.20 $495.90 $33.00 $256.60 $223.30 $214.70 Market Shares Capital Outstanding Million (000's) $493.67 19,739 $5,197.13 177,014 $4,164.03 117,628 $2,191.86 38.623 | $1,348.77 24,523 81.145.88 246.425 $787.78 66,479 $755.55 15.114 $732.58 | 26.805 $587.73 15,846 0.16 2 .46 1.61 0.41 0.11 0.48 0.68 3.64 0.5 0.53 0.58 0.4 0.71 | 0.07 0.21 0.24 0.17 | NS 0.63 0 0.2 0.08 0.01 NA*| 0.31 0 0.12 0.04 0 0.63 $279.60 $0.50 $22.70 $23.40 $0.20 $55.00 $246.80 $0.00 $18.60 So 20 $0.00 $54.90 $555.33 | 21,075 $272.26 3,205 $220.68 9,874 $100 675 506 $57.53 2,935 $44.77 6,498 0.33 0.02 0.12 0 0.08 0 0.06 0 $1.60 $0.00 $0.80 $0.00 $19.88 $8.83 6.670 | 1.762 Stock Price Dec. 02 EDO CORPORATION EDO 25.01 ROCKWELL COLLINS INC COL 29.36 EMBR EMPRS BRSL DE AERO ERJ 35.4 ALLIANT TECHSYSTEMS INC ATK 56.75 ENGINEERED SUPPORT SYS EASI 55 CAE INC CGT 14 .65 AEROFLEX INC ARXX 11.85 MOOG INC CL A | MOG.A 49.99 DRS TECHNOLOGIES DRS | 27.33 TRIUMPH GROUP INC T GI 37.09 Defense ESTERLINE TECHNOLOGY CP ESL 26.35 TASER INTERNATIONAL INC TASR | 84.95 DUCOMMUN INC DCO 22.35 ALLIED DEFENSE GROUP ADG 1 23.55 REINHOLD INDUSTRIES INC R NHDA 19.6 TRANSTECHNOLOGY CORP TT | 6.89 HI-SHEAR TECHNOLOGY CORP HSR 1 2.98 KREISLER MANUFACTURING KRSL 15 .01 Engineering AVIALL INC AVL | 15.6 CURTISS-WRIGHT CP CL CM CW | 44.92 SIMULA INC SMU 1 3.19 TODD SHIPYARDS CORP TOD 17.61 UNITED INDUSTRIAL CORP UIC | 17.97 SIFCO INDUSTRIES INC SIF | 3.95 VALPEY FISHER CORP VPF 1 3.03 Communications and Aerospace AAR CORP 15.3 BE AEROSPACE INC BEAV 5.71 HEXCEL CORP HXL 7.38 HEICO CORP HEI 16.64 PEMCO AVIATION GROUP INC PAGI 334 FAIRCHILD CORP A FA 5.13 CPI AEROSTRUCTURES INC CVU 11.6 AEROSONIC CORP AIM 8.72 HAWK CORP HWK 3.75 ORBITAL SCIENCES CORP ORB 12.18 FIRST AVIATION SRVCS INC FAVS 1 4 .14 ICTS INTERNATIONAL NV ICTS 3.1 SPACEHAB INC SPAB | 1.8 MERCURY AIR GROUP INC MAX 0.97 0.37 NS 0.34 0.29 NA* 0.12 0.15 0.59 1.08 0 1.05 0.16 0.54 0.78 1.53 0 $208.60 $223.60 $59.80 $0.00 $0.00 $10.50 $0.00 $204.80 $222.70 $0.20 $0.00 $0.00 $9.00 $0.00 $492.37 | 31,562 $536.66 | 11.947 $41.96 13,154 $93.40 5,304 $244.19 13,589 $20.35 5,152 $12.68 4,185 0 0.34 0.1 0 0.3 0 0.15 0 AIR 1.05 0.93 0.71 0.4 0.87 | 0.561 12.31 12.06 NS NA* 0.27 0.24 0.24 0.78 0 0.15 $220.80 $787.60 $487.30 $44.00 $174.70 $784.40 $484.60 $44.00 $487.26 $208.95 $285.76 $160.59 31.847 36,594 38,721 9,651 0.04 3.94 3.83 046 $2170 $2040 $135 00 | 4042 0 3 0.5 0.25 0.08 0.18 1.44 0.29 0.55 1.14 0.05 0.02 0.01 3.48 0 0.46 0.26 0.13 2.43 1.55 0.36 0.87 10.85 0.28 0.4 0.4 0.22 0.17 0 0 NS NA* 0.66 . 510411 0.11 $8.30 $0.00 $3.60 $93.60 $140.00 $14.50 $16.20 $80.90 $54.10 $4.30 $129.20 $0.00 $61.31 $0.00 $34.19 $68.70 $32.15 $138.10 $584.08 $14.50 $30.14 $5.90 $20.19 $77.50 $22.31 $50.001 $16.77 25.18 5,285 .921 8,574 47,954 7.281 ,513 12.397 3.289 6 0 1 LMI AEROSPACE INC LMIA 1.99 0.08 0.77 0.65 0.32 $29.30 $8.80 $16.28 8.182 | BB | Table 4 Key Industrial Financial Ratios (Three-year medians 2000-2002) Credit Rating | BBB Investment Grade Noninvestment Grade 13.3 22 1.0 65.7 19.7 33.6 EBIT interest coverage (x) Funds from operations/total debt (%) Free operating cash flow/total debt (%) Return on capital (%) Operating income/sales (%) Long-term debt/capital, book (%) Total debt/capital, book (%) 23.4 214.2 156.6 35.0 23.4 (1.1) 5.0 26.6 6.3 42.2 22.3 18.1 18.1 33.8 42.6 3.9 30.6 12.8 13.1 15.5 40.3 1 47.0 1 10.4 1.5 8.0 14.7 72.6 75.1 7.3 11.5 15.4 53.6 57.7 24.0 21.1 35.9 | | | + Table 5 Capital Market and Financial Information On or Around December 2002 Capital Market Conditions, 2002 U.S. Treasury Obligations Yield 3-mos. 6 mos. 1.670% 1.710% 2.310% 1 yr. 2 yr. 3 yr. 5 yr. 3.160% 3.660% 4.090% 4.520% 4.860% 5.650% 7 yr. 10 yr. 20 yr. Corporate Debt Obligations (5-year) AAA Yield 9.307% 9.786% 10.083% 10.894% 12.753% 14.663% BBB BB Other Instruments U.S. Federal Reserve Bank Discount Rate LIBOR (1-month) Certificates of Deposit (6-month) Yield 1.730% 1.840% 1.980% Prime Interest Rates 4.750% Sources of data: Bloomberg LP, Federal Reserve Bank Reports. Table 6-Historical Returns, 1926-2002 Standard Deviation Large Company Stocks Small Company Stocks Long-Term Corporate Bonds Long-Term Government Bonds U.S. Treasury Bills Average Annual Return 12.20% 16.90% 6.20% 5.80% 3.80% 3.10% 20.50% 33.2 8.7 9.4 Inflation