Star Appliances

Objectives

Evaluate three alternatives for product expansion. To properly make expansion decisions we must first re-evaluate the discount rate currently used in our capital allocation process. Based on the dividend-growth model we review the discount rate and the capital providers required rate of return as well as current Treasury and market returns. Finally evaluate any other factors affecting the cost of capital including inflation rate changes, margins of safety, non-productive investments and financing alternatives.

Procedure:

Using current rates on Treasury bills and bonds we can compare our current discount rate of 10% to determine that our investments are earning far below the risk-free rate of return when they should be exceeding them. Based on this observation we must recalculate our company’s discount rate based on more current data and trends. A more current measure would be to analyze the capital providers required rate of return as Star Appliance Co. is considered an all-equity firm for the basis of these calculations. We will employ the dividend-growth model (i.e. [D1/P0]+g=Ke) to calculate the return expected by shareholders of Star Appliance stock using current dividends paid, current stock price and expected growth rate. In comparing these different rates of return we can assess the significance of their differences and the additional returns on investments necessary to satisfy our investors.

Other Factors Affecting Cost of Capital

Inflation:

We can expect that the government’s estimations of future inflation are accurate and therefore already offset in the rate of return on risk-free assets. Because with our recalculated discount rate we will be exceeding the risk free return we should run our calculations using several future inflation rate estimations to ensure our discount rate withstands various inflation scenarios.

Non-Productive Investments:

In order to keep investing and financing decisions separate we must use the same...