FINANCE MANAGEMENT

CASE STUDY ANALYSIS

Chestnut Foods
Pre read Assignment

Ambudheesh Parasar (G19005)

Naina Rustagi (G19024)

Shiny Panigrahi (G19041)

Sudhanshu Shekhar (G19044)

Date of Submission:28.08.2019

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CONTENTS
1.0 CASE BACKGROUND.............................................................................................................3
2.0 CRITICAL queries and answers...............................................................................................3
3.0 ANALYSIS And INTERPRETATION.......................................................................................5
4.0 recommendations..................................................................................................................8
5. References..............................................................................................................................8

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1.0 CASE BACKGROUND

The Chestnut foods corporation had two main business segments. The first business segment
was Food products division which produced broad range of fresh , packaged and processed
foods for retail and food services. The second business segment was instruments division which
delivered systems and specialized equipment used in the processing and packaging of food
products.The stock market performance of Chestnut foods corporation had started declining
and CFO Brenda Pedersen wanted to reverse the trend. Rollo Van Murr, who was a high-
profile activist investor had purchased 10 % stake in chestnut and was asserting the rights to
two seats on the board. He also recommended to sell off the Instruments division to keep the
focus on food division as speciality bread and pretzel market were Chestnut’s primary driver of
growth.

2.0 CRITICAL QUERIES AND ANSWERS

1. What is hurdle rate in capital budgeting?

A hurdle rate is the minimum rate of return on a project or investment required by a manager or
investor. Hurdle rates allow companies to make important decisions on whether to pursue a
specific project. The hurdle rate describes the appropriate compensation for the level of risk
present—riskier projects generally have higher hurdle rates than those with less risk.1

2. Calculate the Weighted average cost of capital for both the business segments

Weighted average cost of capital = (wd*kd)*(1-tax rate)+(we*Ke)

Wd: Weighted average of Debt Financing

Kd: Cost of Debt
We: Weighetd average of Equity Financing
Ke: Cost of Equity

The Weighted average cost of capital is calculated for both the business segments as follows

WACC Food = 0.23*3.5*(1-0.37) + (0.77*4.85)

WACC Instrument =0.11*3.5*(1-0.37) + (0.89*(6.32 )

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 Instrument
Food Products products
Beta 0.64 1.1
Risk free rate 2.8 2.8
Market risk premium 6 6
Tax 0.37 0.37
Cost of equity 4.85 6.32
Cost of debt 3.5 3.5
Weight of debt 0.23 0.11
Weight of equity 0.77 0.89
WACC 4.23 5.88

3. Is the CFO’s decision to invest in the expansion of the instruments division right? Explain
Solution:
Yes, the CFO’s decision to invest in the expansion of the instruments division is right.
The expected rate of retun on capital in Food was 6.3 % while that in investment division was 7.7 %.
The revenues were also increased by 20 % in 2013.

4. Whose argument is more relevant (Meyer or Suchecki)?

Ans-: Meyer argument is more relevant as-:

a) Different kinds of segments must have different hurdle rates .Food processing industry is the
less risk industry and hence the hurdle rate of return should be less. Machinery and processing
is the high risk industry and hence the hurdle rate of return should be more .
b) If risk factor of individual industry segments are not taken into account then the industry will
wrongly identify the profitable segment or non profitable segment .This will further precipitate
wrong decisions-:
i) Company may identify wrong segment to divest.
ii) Company may identify wrong segment to invest heavily. Wrong investment decisions
could lead to lower returns for investors.
c) The diagram which she outlined to explain the relative position of Food Products and
instruments is correctly outlining that corporate hurdle rate of Food processing and Instruments
should be Risk adjusted.

5. How does the choice of constant versus risk free adjusted hurdle rate affect valuation of Chestnut’s 2
divisions?

Ans-: Steps to calculate hurdle rate (minimum rate of return) -:

a) First calculate the cost of capital for both divisions. This calculation can be done using
comparable companies (Equity Beta).
b) Estimate the cost of equity for each of the divisions.Let’a take market risk premium=6%
Risk free rate=2.8% and the tax rate=37%
c) Estimate the cost of debt for each of the divisions: Chestnut foods have the rating equal to A-
(Equity Beta value is 0.9). Food processing division beta is 0.64.Instrument divisions have 1.13.
d) Risk adjusted cost of capital for food processing division (4.85%) and the instruments division
(6.35%)

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 e) Return on Capital: Food processing division (6.3%) Instrument division(7.7%)
So conclusion is investment can be done in both the divisions.

Constant cost of capital : 7%.

Return on Capital: Food processing division(4.85%),Instrument division: 7.7%

Hence instrument division is much riskier than food processing division of the company .

3.0 ANALYSIS AND INTERPRETATION

 Cost of capital is basically the opportunity cost that a firm makes for a specific investment. It is a
picture of the best return that the investor can expect for a similar kind of investment. Investor are
persuaded for higher risk when the associated return is higher. So, in order to set the things straight
market forces sets the hurdle rate for the investor that effectively suggest the cost of capital .

Since , the main discussion was based on hurdle rate (whether for both the division the hurdle rate
should be same or be different ) so we tried to investigate the case from the perspective of cost of capital
and then compared the individual cost of capital for both the division.

S&P Bond Total Equity (Book Total Equity

  Equity Beta Rating Total Debt Value) (Market Value)
Chestnut
Foods 0.9 A- 461 1544 1840
           
Food
Processing          
Boulder
Brands 0.55   298 355 958
Campbell 0.6   4832 1349 13223
ConAGra
Foods 0.7   9590 5472 13805
Diamond
Foods 0.75   593 167 578
Flowers
Foods 0.5   923 1076 4429
General Mils 0.55   8645 6633 31245
Hormel Foods 0.65   250 3311 11759
Kellogg 0.6   7358 3545 21841
J.M. Smucker 0.7   2241 5168 10904
Tyson Foods 0.8   1942 6285 11469
Average Beta 0.64 Total Debt 36672 33361 120211
Total when Total whenEquity
      Equity taken taken at market  

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 at Book value value
weight of
debt
    financing 0.523638856 0.233753817  
weight of
equity
    financing 0.476361144 0.766246183  
           
           
Instrument          
Badger Meter 1.06   89 197 723
Dresser Rand 1.14   1287 1297 4549
Flowserve 1.3   1200 1870 10767
Honeywell 1.25   8829 17467 74330
Idex 1.15   774 1573 5933
Measuremen
t Specialities 1.35   129 331 944
Mettler-
Toledo 1.1   413 935 7154
Wendell
Instruments 0.52   0 98 230
Avg Beta 1.10875 Total 12721 23768 104630
Total when
Equity taken Total Equity taken at
      at Book value market value  
Weight of
debt
    financing 0.348625613 0.108401292  
weight of
equity
    financing 0.651374387 0.891598708  
           

Capital Asset Pricing Model Value

Ke=rf+β(rm-rf)  

rf 0.028

β company 0.874375

β food 0.64

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 β instrument 1.10875

rm 0.06

Cost of Equity (Instrument) 0.06348

Cost of Equity (Instrument)
percent 6.35%

   

Cost of Equity Chestnut 8.20%

   

Cost of Debt 0.04

   

Cost of Equity (Food) 4.85%

WACC-Equity at
Divison Hurdle Rate market WACC-book value

FOOD 0.07 0.042317212 0.048709177

INSTRUMENT 0.07 0.058988934 0.064285881

(wd*kd)(1-tax rate)+(we*Cost
WACC of instrument of equity of instrument)  
  0.059 0.064
     
     
WACC of Food Equity at market value Equity at book value
  0.042317212 0.048709177
     
     
Expected Economic return -Instrument 2113.61655  
Expected Economic return -Food 2774.1289  
Total 4887.74545  
Economic Return - Chestnut Foods 1872.27  

For food processing , the total debt was $36672(all values are in million dollars ) and total equity was
$120211.Total weight for debt financing comes out to be 0.233 whereas the equity financing it comes out
to be 0.767.

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 For Industry , the total debt was $12721 whereas the total equity comes out to be $104630.Total weight
for debt financing was 0.108 whereas the weight of equity financing was 0.892.
By solving this further, we found that cost of equity for food came out to be 4.85% , cost of debt 4%. Cost
of equity for instrument came out to be 4.2% whereas the cost of debt for instrument came to be 6.4%.
We found the WACC- for food to be 4.2% and for the instrument it was 5.8%.

By using the formulae for economic benefit :- (Expected return of capital- weighted average of
capital)*total division capital ) we found that
Expected Economic return for instrument to be $2113.66 whereas the expected economic return for food
comes out to be $2774.13. Expected economic return for instrument came out to be 44% of the total
whereas for expected return for food came out to be 56% of the total expected return.

4.0 RECOMMENDATIONS

Our recommendations on the Case Study of Chestnut Foods: Division of Cost capital are as follows:

 The sale of Instruments Division of Chestnut Foods might have an opposite effect of degrading
the stock price rather than increase the stock price. The market image might get hit badly.
Hence, the CFO of company, Brenda Pedersen should not sell the Instrument division of the
company.
 As the instruments division pulls in a major revenue of the company as a whole and the sales
growth rate is almost 20% in the current year of 2013, sale of the division will forgo all these
positives. In addition to this, the food products division of Chestnut foods sources majority of
its machinery requirement from the Instrument Division which is almost 20% of the division’s
revenue. If Instruments division gets sold, then the Food Product Division might have to source
the machinery from outside and that to at a higher price. This will result in the increase of
procurement prices and a decreasing profit for the company.
 Considering the expected return on capital for both divisions, the expected return of Instruments
division forms almost 43% of the company in future which seems to be quite promising and
hence, the division must continue.
 CFO of Chestnut Foods Ms Brenda Pederson must convince Van Muur not to sell the the
instrument Division and focus on the long-term return of the company by continuing both the
divisions and gain competencies in both.
 Also, Ms. Brenda must request and convince Van Muur to support her proposal for one-billion-
dollar investment in the Instrument Division of Chestnut Foods.

5. REFERENCES

https://www.investopedia.com/terms/h/hurdlerate.asp

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