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The case study describes Chestnut Foods (Chestnut), which faces stock acquisitions by an activist investor. The new investor's plan goes against the CFO's plan in regard to selling Chestnut Food's high-growth division. In the case study analysis of Chestnut Foods, students are invited to work with the risk-adjusted performance of each of Chestnut Food's divisions and estimate division-specific hurdle rates.
Michael J. Schill; Donald Stevenson
Darden Business Publishing (UV7014-PDF-ENG)
Aug 6, 2015 (Revision: Nov 17, 2015)
Case questions answered:
- Should Chestnut Foods separate the two divisions?
- Is Meyer's risk-adjusted hurdle rate too steep?
- Why is Van Muur soliciting control of Chestnut?
- Do you agree with Meyer’s dinner conversation assertions? Estimate a risk-adjusted cost of capital for the two business units and comment on whether Meyer’s graph is accurate (case Figure 1). In estimating the cost of capital, please consider WACC estimates based on comparable companies. How does the choice of a constant versus risk-adjusted hurdle rate affect your evaluation of Chestnut’s two divisions? Finally, what is the economic profit for each division?
- Do you support Pederson’s proposal? In light of the recent developments, is her investment and identity proposal more relevant? What recommendations should Pederson make to respond to Van Muur?
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Case answers for Chestnut Foods
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1.0 Company Background – Chestnut Foods
Chestnut Foods started out as a bakery in 1887 and grew into a distribution service by 1920. Since then, Chestnut Foods has purchased numerous companies and has become quite diversified with products and services ranging from consumer goods, distribution, food production, utilities, military and aerospace programs, and industrial and residential applications.
The company has two divisions, Food Products and Instruments. The company was valued at $1.8 billion, with an annual profit of $130 million in 2013.
1.1 Food Products Division
The Food Products division consists of producing a broad range of fresh, prepackaged, and processed foods for both retail grocery distribution and institutional food service.
Chestnut has consistently retained portions of the market for institutional ready-to-bake frozen dough. These specialty breads have been Chestnut’s primary driver of growth.
Customer surveys have reflected consistent high ratings for Chestnut’s product quality, freshness, and flavor. This division has had a consistent 2% annual growth with a net operating profit after tax of $88 million and net assets totaling $1.4 billion.
The Food Products division accounts for 20% of the company’s revenue, with an expected return on 6.3% capital.
1.2 Instruments Division
The Instruments division of Chestnut Foods includes delivered systems and specialized equipment used in the processing and packaging of food products. The division provides a variety of quality control and automation services used within the company.
Although mostly overseas, the division provides support for many North American producers. There is a high demand for this division but requires substantial investment in R&D and fixed assets.
The company takes great pride in its quality manufacturing process and believes the Instruments division is an important differentiator among investors and consumers.
The Instruments division accounts for 60% of the company’s revenues, with sales increasing by 20% in 2013. The net operating profits after taxes totaled $46 million and net assets $600 million. The expected return on capital is 7.7%.
2.0 Cost of Capital Principles
The cost of capital refers to the opportunity cost of making a specific investment. The rate of return could have been earned by putting the same money into a different investment with equal risk.
Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment. It reflects the best rate of return that investors expect to get on their investments of similar risks.
Like the ones at Chestnut Foods, business managers use the cost of capital to establish the company hurdle rates for acceptable, expected rates of return. When a project is expected to have a rate of return higher than its cost of capital, economic value is added, and the project is accepted.
When considering risk, investors expect to get a higher return on riskier investments. Securities with more risk will demand higher risk premiums. Investors will only invest in a project where their expected return compensates for their associated risk.
Therefore, the cost of capital is set by market forces based on prevailing rates of return that exist in the financial markets. Firms consider this of investors and set hurdle rates that effectively reflect the current cost of capital.
When a company has multiple divisions, it can have multiple hurdle rates to compensate for the different risks associated with the different divisions. Chestnut Foods is made up of two divisions that are completely different industries.
As of now, Chestnut Foods has used only one hurdle rate to represent both divisions. The conversation of changing this has come up, though. Managers must come to a decision on whether it is time to change to multiple hurdle rates for the two divisions.
After years of failing to meet stock expectations, CFO Brenda Pederson has announced her plans in management to reverse the negative trend. She wants to acquire a $1 billion investment into the Instruments division and change the company name to better fit the company’s identity.
Believing that the Instruments division is the more profitable and most promising division, Pederson wants to rename Chestnut Foods to CF Industries. Trying to switch management direction, a high profile activist investor, Van Muur, purchase 10% of the company and is asserting that the company sells off the Instruments division and focus on the Food Products division.
When looking at the current hurdle rate for Chestnut Foods, Pederson would be…
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