Case 1 Risk and Rates of Return

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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, 5th 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

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 (KS) had to be examined with the CAPM formula. Following, the observed KS 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 |High risk (*1,2)| | | | | | |(*1,0) | | |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 | | | | | | | | | | |...
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