Sterling Households Products Company Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

Problem Statement:

Sterling is operating under consumer products and generating healthy profits for years. The sales growth has declined in recent years, although it is positive, but it can be negative in the future years if the innovative decision is not taken by the company. It has a well-diversified portfolio in the consumer goods, but now it is looking forward for other than consumer products to sustain positive growth. The decline in growth has made the company to take a decision to switch towards other markets that has high growth rates.

Analysis:

The analyses are based on the acquisition plan of the production unit of germicidal, sanitation, and antiseptic that is currently under the control of the Montagne Medical Instruments Company. The company has a good market reputation and a proposed acquisition of Sterling Housing Products to diversify in medical instruments. The detailed analyses are given below.

What is the cost of equity of the investment appraisal?

Cost of equity is the required return of the shareholder of an entity.The return isa combination of the capital gain and the dividend receipt. There are many methods to calculate the cost of equity and in this appraisal, the capital asset pricing model (CAPM) is used to calculate the cost of equity. CAPM is one of the most acceptable methods of calculating cost of equity due to its nature to incorporate both systematic risk and financial risk.

In the CAPM model, there are some factors to be considered and those are given below.

The first thing is the beta asset of the industry; an industry beta asset is same for all those companies operating under the industry. This represents the systematic risk that cannot be reduced by an individual company because the risk is related to the industry specific and economy in which it operates.
The other thing is debt and equity ratio, the ratio of debt and equity must be known because the debt comes withan extra financial risk to the company.The financial risk can be reduced through less debt financing or I can be eliminated with no debt financing.
The risk free rate has an impact on the cost equity return as it has a positive relationship with the cost of equity.
Another thing is the market risk premium that a company pays extra to that risk free rate. It has also a positive relationship with cost of equity.
The final component is taxation, the tax saving can flow to the entity on paying interest on debt financing.

Beta asset is the industry risk or system risk when financial risk is incorporated into beta asset, then it becomes beta equity that is necessary to calculate the cost of equity. Beta asset and beta equity also have a positive relationship with the cost of equity.

The cost of equity is 8.3 % (WACC exhibit) for the investment appraisal. This is the required return of the shareholders from the targeted capital structure that is defined in detail in the next part of this report.

What is the correct capital structure and weighted average cost of capital?

The correct capital structure for the investment appraisal is the targeted capital structure that Sterling is under consideration to change. The calculations of betas in the above part are based on the targeted capital structure of the company. It has targeted capital structure of 30% debt financing and 70% equity financing.

Currently, it has 80% of equity and 20% of the debt, therefore it is going to raise the debts to finance the new acquisition and its expansion plan. The debt financing will definitely affect the ratio and it will change to 30% debt and 80% equity ratio.

The weighted average cost of capital for the project appraisal is 6.81% (WACC exhibit). This is based upon the targeted structure of the company, the new percentage of the cost of debt not of tax and also the cost of equity derived in the last part of this report.

WACC for different years is different due to changes in the market returns and other factors that are considered while calculating the required return. It is the limitation that the same rate has been used for many years of investment tenor without considering the changes in the required returns.

Sterling Households Products Company Case Solution

The cost of debt is 5.1% gross and the net of tax cost of debt is 3.32% (WACC exhibit).

What are the free cash flows of base case acquisition opportunity till 2022?

The free cash flows are for the base case investment appraisal of the propose acquisition plan. The free cash flow is one of the most appropriate methods for investment appraisal because it appraises the investment on the basis of real terms of money adjusting the required return of the investors...............