978-1259277160 Case Case 17

Galaxy Systems, Inc. Case 17

Divisional Cost of Capital

Purpose: The case combines risk analysis with discount rate considerations. To emphasize how many

multidivisional corporations operate, the case actually gets into the topic of divisional hurdle rates. The

student is able to see how different divisions in a corporation might have different required rates of return

based on their risk exposure. In this particular case, a key risk measure for the consideration is beta. The

student does not have to actually compute betas, only observe how they might be used. A simple

definition of beta is also included in the case. Calculations related to net present value and internal rate of

return are purposely simple to emphasize more conceptual items. Actually the IRRs can be found as exact

values from Appendix D after only one calculation.

There also is additional emphasis on how financial decisions are made in a corporate culture.

Relation to Text: The case should follow Chapter 13. It also draws on material from many of the capital

budgeting chapters.

Complexity: The overall case is moderately complex and should require 1 hour.

Solutions

1. Proposal A

a)

Investment (PV )

IRR Annuity ( )

$2,355,600 5.889 n 10

$400,000

IRR 11%

A

=

= = =

=

Appendix D

b) NPV (10% discount rate for the auto airbags production division)

Cost $2,355,600

Proposal B

a)

$2,441,700

IRR 5.426 10

$450,000

IRR 13%

n= = =

=

Appendix D

b) NPV (15% discount rate for the aerospace division)

Cost $2,441,700

Proposal C

a)

$145,680

IRR 9.712 15

$ 15,000

IRR 6%

n= = =

=

Appendix D

b) NPV (10% discount rate for the auto airbags production division)

Cost $145,680

A = $15,000, n = 15, i = 10%

Present value of inflows = $15,000 x 7.606 = $114,090

Present value of inflows…………………………………………………………………………………………..$ 114,090

Cost……………………………………………………………………………………………………………………….–145,680

Net present value…………………………………………………………………………………………………….($ 31,590)

Proposal D

a)

$1,262,100

IRR 4.207 8

$300,000

IRR 17%

n= = =

=

Appendix D

b) NPV (15% discount rate for the aerospace division)

written consent of McGraw-Hill Education.

2. Proposal A should be accepted

Proposal C should be rejected

Proposal D should be accepted

3. While the decisions related to Proposals A and B appear to be straightforward, Proposals C and D

require further discussion.

Proposal C has a negative net present value and the internal rate of return of 6% is well below the

required rate of return of 10%. Nevertheless, it calls for the development of special equipment to be

used in the disposal of environmentally harmful waste material created in the manufacturing process.

Proposal D has a positive net present value and the internal rate of return of 17 percent is well above

the required rate of return of 15 percent for the division. However, the proposal appears to have even

greater risk than projects normally undertaken in the aerospace division. While the high required rate

of return for this division is supposed to cover the risk exposure of dealing in federal government

4. The $300,000 that has already been spent on the initial research for Proposal B (radar surveillance

equipment) is a sunk cost. The money has already been spent and should have no influence on

subsequent decisions. Sometimes in the real world, egos get in the way of corporate decisions, and

written consent of McGraw-Hill Education.

Of course, even if we considered the $300,000 that had already been spent, it would raise the total

cost of the project and make it even less economical.

Further Overall Comments

Companies that use divisional required rates of return often do have difficulties in finding betas for firms

that produce products comparable to a division. That is, finding a “pure play” comparison is difficult.

Therefore, using the average beta for an entire industry may be the next best alternative. For example, if a

division produces machine tools, its beta may be inferred from the entire machine tool industry rather

than from a given firm in the industry.

This case also demonstrates the “politics” involved in the capital budgeting process by managers in their

respective divisions desiring to attract capital to their budgets and maximize their individual performance.

written consent of McGraw-Hill Education.