FINANCIAL MANAGEMENT

ASSINGMENT SUBMISSION

CASE#8 CHESTNUT FOODS-Revision#1

Team members:

S. Chandra Prakash (CGT19010),

M. Manjunathan (CGT19011),

Prashant Sharma (CGT19021),

Shivam Agrawal (CGT19026)

PART A: CASE BACKGROUND:

Chestnut food was founded by Mr. Otto Chest nut in 1877 as a food selling
company. Chestnut foods grew both organically and inorganically over the years
and went public in 1979. By 2013 company was valued at 1.8 Billion Dollars with
annual profit of 130 Million Dollars.

Now Chesnut foods operates in two divisions:

a) Foods Division: Produced fresh, prepackaged and processed foods for retail and
food services. The division achieved an average annual growth rate of 2% during
2010 through 2013. In 2013 food division net operating profit after tax (NOPAT)
and net assets were worth 88 Million dollars and 1.4 billion dollars. For future
return on capital for the division were expected to be 6.3%.

b) Instrument Division: Chestnut Food had developed a strong expertise in food

process instruments over the years as it was using a lot these instruments. In 1991
chestnut purchased Consolidated Automation systems, a medium – sized food
processing instrument equipment company and hence instrument division was born.
Subsequent purchases were done by Chest nut after successful results in Instrument
division. It delivered systems and specialized equipment used in the processing and
packaging of food products. It provided a variety of quality control and automation
services used within the company. Instrument division supplied 20% of its revenue
to food product division. In 2013 instrument division sales has increased by 20%.
The NOPAT was 46 million dollars and net assets were 600 million dollars. The
expected return on capital was expected to be 7.7%.

The company took increasing pride in the high quality of its manufacturing process
and believed it to be an important differentiator among both investors and
consumers.

S. Chandra Prakash (CGT19010), M. Manjunathan (CGT19011), Prashant Sharma

(CGT19021), Shivam Agrawal (CGT19026)
Instrument Division Highlights:

The current hurdle rate set by company for raising any capital is 7%.

PART B: PROBLEMS:

In recent years, chest nut’s shares had failed to keep pace with either the overall
stock market or industry indexes for foods or machinery as shown in Exhibit-1 in
Case. Subsequently company’s credit rating has been downgraded to A- by S&P.
Some attributed this downfall due to increasing competition and changing demand
of the industry. An Analyst mentioned “Chest nut has become vulnerable to a
hostile takeover as a vacant umbrella on a hot beach “.

Hence CFO Brenda Pedersen wants to take steps to reverse this declining trend.
Brenda has proposed two strategic initiatives:

a) 1Billion dollar investment in company growth to expand the instrument division.

b) Adoption of a more progressive corporate identity.

However, Brenda is told that, a business man Van Mur buys a 10% of Chest nut,
seeing that the chest nut share price is depressed, and seeks a seat on the board and
a new management direction. He is recommending that instrument division be sold
off and the company should make focus towards the food division as it is its core
activity. The reason he is recommending for sale may be to get more out of its
investment. Instrument division is growing at an excellent rate and will result in
high benefit for shareholder if it is disposed of now.

Brenda Pederson called all the VPs to discuss the proposal for these two initiatives
and to discuss proposal for different hurdle rates for different divisions. She
believes that both the division have different degree of risk and hence the evaluation

S. Chandra Prakash (CGT19010), M. Manjunathan (CGT19011), Prashant Sharma

(CGT19021), Shivam Agrawal (CGT19026)
of both the divisions cannot be done on the basis of a single hurdle rate. In food
division, the cost of capital is 6.3% while in instrument division it is 7.7 %. The
company’s current hurdle rate is 7% to evaluate any project. VP Meyer also
supported this view and explained all on the basis of the graph shown below .
However there has been no consensus between the management for making
different hurdle rates. For example, VP of instrument division believed that the
hurdle rate of both instrument division and product division should be same.

The issues for which Brenda needs to find solution can be summarized as:

a) To find out whether instrument division was performing well or not as asserted
by Van Mur or Meyer? To correctly evaluate the performance of both the divisions.

b) How to convince VPs and management for different hurdle rate for different
division, which as per Brenda is important to take a correct business decision
regarding investment?

c) How to convince the management to negate the influence of Van Mur on the
company’s management for selling the instrument division.

d) Is her proposal for changing corporate identity of instrument division good? How
to convince the management

e) How to convince management & Van Mur to generate 1Billion dollars for
investment in Instrument division expansion? How to influence the investors to
invest in Chestnut because of the high valued offerings that the instrument division
maintained.

S. Chandra Prakash (CGT19010), M. Manjunathan (CGT19011), Prashant Sharma

(CGT19021), Shivam Agrawal (CGT19026)
 Constant vs Risk adjusted Hurdle rate
10

8
Rate of Return

3
Risk Level

Risk Adjusted Hurdle rate Company's Hurdle rate

C) Interpretation and Analysis:

For analysis, the WACC of whole Chestnut (7%)

will not be taken into account for calculation, since risk involved, and rate of return
is different for these individual units of Chestnut. If we take 7% as required rate of
return, then food division will always be lacking investments, so it is appropriate to
consider the both divisions differently.

Food Division:

We have considered, Beta for the food industry is considered from the average of
given comparable industries. And also Debt and equity ratio for the food industry is
taken from the average of given comparable industries.
Total Equity
Name Equity Beta Total Debt Debt % Equity% Asset Beta
(Market Value)
Boulder Brads 0.55 298 958 24% 76% 0.5
Campell Soup 0.6 4832 13223 27% 73% 0.5
Conargra foods 0.7 9590 13805 41% 59% 0.5
diamond foods 0.75 593 578 51% 49% 0.5

S. Chandra Prakash (CGT19010), M. Manjunathan (CGT19011), Prashant Sharma

(CGT19021), Shivam Agrawal (CGT19026)
 floowers food 0.5 923 4429 17% 83% 0.4
generel mills 0.55 8645 31245 22% 78% 0.5
hormel foods 0.65 250 11759 2% 98% 0.6
kellogs 0.6 7358 21841 25% 75% 0.5
JM Sumucker 0.7 2241 10904 17% 83% 0.6
Tyson food 0.8 1942 11469 14% 86% 0.7
Industry Beta' 0.64 24% 76% 0.53

We have taken the credit rating as BBB, based on the comparable food industries
rating. From the calculation we get cost of equity as 6.64%, cost of debt as 2.21%
and WACC as 5.6%.

Instruments Division:

We have considered, Beta for the Instrument industry is considered from the average
of given comparable industries. And also, Debt and equity ratio for the Instrument
industry is taken from the average of given comparable industries.
Total Total Equity Asset
Name Equity Beta Debt % Equity%
Debt (Market Value) Beta
Badger Meter 1.06 89 723 11% 89% 1.0
Dresser Rand 1.4 1287 4549 22% 78% 1.2
Flowserve 1.3 1200 10767 10% 90% 1.2
Honeywell 1.25 8829 74330 11% 89% 1.2
Idex 1.15 774 5933 12% 88% 1.1
Measurement Specialties 1.35 129 944 12% 88% 1.2
Mettler-toledo 1.1 413 7154 5% 95% 1.1
Wendell Instruments 0.52 0 230 0% 100% 0.5
Industry Beta 1.14 12% 88% 1.13

We have taken the credit rating as BBB, by comparing with comparable firms
related to instruments business. From the calculation we get cost of equity as
10.16%, cost of debt as 2.58% and WACC as 9.3%.

D. RECCOMENDATIONS:

The expansion of the instrument division requires Chestnut Foods to raise the funds
of one billion dollars. The point of argument is to decide whether the Food and

S. Chandra Prakash (CGT19010), M. Manjunathan (CGT19011), Prashant Sharma

(CGT19021), Shivam Agrawal (CGT19026)
Instrument division should have separate Hurdle rate or there should be same hurdle
rate throughout the company.

The two divisions of Food and Instrument are operating in very different
markets and should be treated differently. As pointed out in the case, Food Market
gives less returns but is less risky while Instrument market give more return but has
higher risk. So, we considered the two markets separately and calculated CAPM for
both the divisions.

Kd depends on credit rating because investors refer to rating of business to demand

interest rate. Beta also depends on market. So, we derived the Kd and Ke separately
for both the markets viz Food & Instrument.

On calculating, we got WACC for food and instrument division as 5.7% & 9.3%
respectively.

On the basis of this calculation, the CEO of the company has to invest in instrument
division. The reason for this is that WACC of instrumental division is higher than the
food product division. The company will get higher return from this division than
product food division.

The food product division of the company has stable sales and there is no risk. Along
with that, the beta of the company is lower. This shows that company is not risky.

Should Instrument division be sold?

The proposal by Van Muur is to sell the instrument division and diver the company’s
focus only on a single direction. The proposal might result in increase of the share
price of the company, as the management will have to look after one single division
that helps them to make effective decisions for the company.

No, we should not sell Instrument division. The selling of the instrument’s division
might have a negative impact on the company’s image and the stock price. The CFO
of the company should not sell the company’s instruments division, the reason for

S. Chandra Prakash (CGT19010), M. Manjunathan (CGT19011), Prashant Sharma

(CGT19021), Shivam Agrawal (CGT19026)
this is that it is a major source of the revenue for the company. Along with that, the
food product division requires many food processing machineries that accounts for
20 percent of the instrument division sales. The food products division must either
import or buy the machinery from other companies, which might result in a loss to
the company’s income.

S. Chandra Prakash (CGT19010), M. Manjunathan (CGT19011), Prashant Sharma

(CGT19021), Shivam Agrawal (CGT19026)