case1_03

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Divisional hurdle rates Financial management and policy Case 1, week 2 University of Maastricht Faculty of Economics and Business Administration Maastricht, 5 th of November 2003 Danner, W. I 136964 Kuijt, R.J. I 130885 Steenvoorden, W.J.M. I 178829 Course Code: 6010v Group number: 7 Subgroup number: 1 Tutor: B. Pavlov

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Introduction Randolph Corporation is a multidivisional company. Due to frictions among the divisions, Randolph’s stock has not performed according to expectations. In order to improve Randolph’s financial situation and position among its competitors, a number of questions need to be answered. We will discuss these questions separately below. Question 1: Estimate the divisional hurdle rates, taking a 45% debt ratio into account Question 2: We can identify high risk, average risk and low risk projects. What hurdle rates would be assigned to each division? In order to calculate the divisional hurdle rates for each division, first the cost of capital (K S ) had to be examined with the CAPM formula. Following, the observed K S can be plugged into the WACC formula in order to find the divisional hurdle rate for average risk. Because of the given debt-structure of 45% the cost of debt has to be multiplied by 0.45. The given cost of debt is 11% for each division. The average risk divisional hurdle rate has to be multiplied by 0.90 or 1.2 in order to receive the low risk and the high risk hurdle rates respectively. The results can be observed in table 1. Division Beta Ks* WACC* Project Hurdle rates* Low risk (*0,9) Average risk (*1,0) High risk (*1,2) Real estate 0.600 0.113 0.092 0.083 0.092 0.110 Ceramic Coatings 0.950 0.132 0.102 0.092 0.102 0.123 Equipment manufacturing 1.050 0.138 0.105 0.095 0.105 0.127 Home products 0.650 0.116 0.093 0.084 0.093 0.112 * KS = KRF + b *(KM-KRF) = 8%+ 0.6 *(13.5%-8%) = 11,3% * WACC = WF*(KD)*(1-T)+WS*( KS ) = 0.45 *(11%)*(1-40%) + 0.55*(11.3%) = 9,20% * Hurdle rates = WACC*Amount of risk involved Table 1 Divisional hurdle rates Question 3: How can the 1.2 and the 0.9 risk adjustment factors be explained? Is there a theoretical foundation for it? In general, differentiation in hurdle rates between projects with different types of risks is preferable. If all projects with different types of risk will have the same hurdle rates, managers would probably choose the most risky project, due to higher expected returns. This in turn would also drive the divisional beta up. Therefore, it seems to be justified to make a 2
distinction in hurdle rates depending on the level of risk involved. That means that managers also take projects with lower risk into consideration. However, it cannot be said with certainty if the adjustment factors need to be exactly 0.9 or 1.2. Nevertheless, the spread between the adjustment factors should not be too wide, in order not to neglect profitable projects or accept unprofitable ones. Question 4:

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