case1_05

case1_05 - FINANCIAL MANAGEMENT AND POLICY DIVISIONAL...

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FINANCIAL MANAGEMENT AND POLICY DIVISIONAL HURDLE RATES RANDOLPH CORPORATION (Case1) 8 th November 2005 Universiteit Maastricht Faculty of Economics and Business Administration Financial Management and Policy 3020B Tutor: J.Budek Tutorial Group: 2 Dehnadi, Zahir I252786 Sprengers, Rutger I232785
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Errata: The weighted average corporate beta on page 2 of the Randolph Corporation case has been conducted incorrectly. The product of “percentage of corporate assets” and “estimated divisional beta” of the Ceramic Coatings division has been calculated as 0.195, whereas it should have been 0.095 (alternatively the product of 0.195 is correct but the estimated divisional beta should have been 1.95 instead of 0.95). This in turn influences the weighted average corporate beta and the corporate cost of equity which should have been 0.795 and 12.4% respectively. Nevertheless, the corporate cost of equity is not explicitly applied throughout this paper and hence this errata will neglected and the calculations will be done . Introduction: The case at hand deals with Randolph Corporation, which is a multi-divisional producer of abrasive products, industrial grinders and sharpeners, and coated ceramics. The company decided on a product structure, which resulted into four seperate3 divisions: home product division, equipment manufacturing division, ceramic coatings division and residential real estate. Recent organizational problems and poor stock performance led to the appointment of a special committee to ameliorate the company's positions and improve the realm of risk management. Teh following key issues can be underlined: divisional hurdle rates, project measurement and capital structure. Questions: 1. For computing the divisional hurdle rates a debt ratio of 45% will be employed. Then the costs of equity for each division will be calculated by utilizing the CAPM and taking the betas given in the Randolph corporation article. The risk free rate is set at a treasury bond rate of 8% juxtaposed to the 13,5% long run rate of return of the market. Considering a tax rate of 40%, the cost of capital can than be acquired by utilizing the WACC formula. The cost of debt is at 11%. The WACCS are shown in the following table: Divisional beta Cost of equity R=Rf +ß(Rm-Rf) WACC =B/(B+S)*rb*(1-T)+S/(B+S)*rs Real Estate 0.60 11.3% 9.19% Ceramic Coatings 0.95 (1.95 error case) 13.23% 10.24% Equipment Manufacturing 1.05 13.78% 10.55% Home Products 0.65 11.58% 9.34% Table 1: Cost of equity and WACC
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2. The risk adjusted hurdle rates are computed by taking the divisional WACCs and multiplying them with the appropriate risk-factor. As mentioned in the case, high risk projects demand 1.2 times the divisional rate, low risk projects are estimated at 0.9 times the divisional rate, whereas average risk projects go with their divisional rates. The results can be retrieved below: WACC high risk average risk low risk Real Estate 9.19% 11.03% 9.19% 8.27% Ceramic Coatings 10.24%
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This note was uploaded on 11/16/2009 for the course F 3033 taught by Professor Hh during the Spring '09 term at Maastricht.

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case1_05 - FINANCIAL MANAGEMENT AND POLICY DIVISIONAL...

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