Case Scenario:
Concordia Electronic Systems Test was organized into two fairly distinct businesses that were roughly equal in size. The Systems Division was a major developer and marketer of software used in a wide range of applications. The Test Equipment Division manufactured, marketed and serviced electronic test equipment- a business characterized by high cyclicality.
Concordia’s use of debt was moderate, in line with industry practice. It’s total debt was 15% of equity at market (debt equal to 13% of capital). Management believed that the Systems Division was able to support a debt level equal to 20% of equity; while the more volatile Test Equipmetn Division could support only half the amount.
Management had historically used the company’s overall cost of capital, estimated at 16% , to evaluate the economic attractiveness of all projects. Recently, the Executive Vice President of the Systems Division had challenged the appropriateness of using the same discount rate for the Systems Division as for the Test Equipment Division. To support this position, the Executive Vice President pointed to the greater riskiness of Test Equipment operations, as indicated by the equity betas of companies in each of the two industries (see exhibit 1)
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Debt as % Equity
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Equity Beta
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1995
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1996
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Asset Beta
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Test Equipment Manufacturers
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Teradyne
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2.15
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2%
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1%
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2.13
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GenRed
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2.32
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0%
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0%
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2.32
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Hewlett-Packard
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1.67
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19%
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5%
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1.59
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Average
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2.01
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Software Developers
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Autodesk
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1
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0%
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0%
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1
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BMC Software
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1.4
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0%
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0%
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1.4
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Corel
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1.15
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0%
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0%
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1.15
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Mentor Graphics
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1.25
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16%
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11%
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1.13
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Microsoft
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1.15
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0%
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0%
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1.15
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Sybase
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1.3
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0%
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0%
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1.3
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System Software
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0.95
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74%
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21%
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0.78
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Average
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1.13
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Concordia Electronic Sytems
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1.95
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19%
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15%
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Question 1
Please estimate Concordia’s overall cost of capital. Assume that long term Treasury yields are 6.5%, yields on Treasury Bills are 5.12%, Concordia’s tax rate is 40%, and that Concordia’s borrowing cost is 8%. Information on equity risk premiums is provided in Exhibit 2.
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I. Spreads Between S&P 500 Composite Returns and Lont-Term U.S. Government Bonds
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1802-1992
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1871-1992
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1926-1992
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1946-1994
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1965-1994
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1975-1994
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4.60%
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5.50%
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6.80%
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6.60%
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3.10%
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6.30%
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II. Equity Risk Premium In Four countries (Stock Market Return (-) Return on Short-Term Treasuries)
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Canada
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Switzerland
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Japan
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USA
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1950-1987
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1926-1987
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1973-1987
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1951-1987
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6.50%
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-7.00%
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6.00%
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7.30%
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Question 2
What is your estimate of the cost of capital for each of the two divisions?
Question 3
Would you recommend that Concordia use a single company-wide discount rate to evaluate all projects, or different rates for each division?