Star Appliance Company (a)

Abstract

An introduction to estimating the cost of capital, this case provides sufficient data for using a variety of methods for estimating the cost of equity, including the capital-asset-pricing model, and allows students to use their cost of capital in analyzing several investment projects. See also the B case (UVA-F-0684).

Excerpt

UVA-F-0421

STAR APPLIANCE COMPANY (A)

Arthur Foster, the financial vice president of Star Appliance Company, thought that the opportunity had finally presented itself. Since joining the company in early 1978, he had been concerned about the hurdle rate used in the capital allocation process. He had not wanted to create a controversy immediately after accepting his position, but now in early October 1979, with the company considering a move into new products, he thought that the time had come to discuss the company's cost of capital.

History of Star Appliance Company

Star Appliance was founded in 1922 by Ken McDonald to manufacture electric stoves and ovens. During the prosperous 1920s, the demand for electric stoves and ovens as replacements for wood- and coal-burning stoves increased, and Star became a respected brand name and the market leader. Capitalizing on this success and the burgeoning equity market during the 1920s, McDonald financed the rapid growth of the company through the sale of common stock. This move proved to be farsighted. The company was able to enter the Depression with a debt-free balance sheet. Many firms, plagued with dwindling sales and poor or nonexistent profits had defaulted on their debts and were forced into bankruptcy and eventually out of business. Star suffered much during the Depression, but was able to survive by significantly reducing its operations and concentrating its sales efforts on the least affected part of the market, the premium end. As a result, Star remained alive and viable, emerging at the end of World War II with a smaller base of operations, a strong balance sheet, and a well-established reputation in the marketplace.

In the ensuing three decades, the company grew and prospered. Star continued to concentrate on the premium market and over the years expanded its product line. Continuing its focus on kitchen appliances, Star first added gas ranges to its products, followed by a line of refrigerators. Microwave ovens were the company's latest product. The company's marketing program emphasized the sale of new appliances as replacements for older models, rather than targeting the market for installations in newly constructed dwellings. This strategy provided some protection from the vicissitudes of the highly cyclical housing industry.

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Keywords: capital asset pricing model, capital investment, cost of capital