Why do think Larry Stone wants to estimate the firm’s hurdle rate? Is it justifiable to use the firm’s weighted average cost of capital as the divisional cost of capital? Please explain. (10% weighting)
The hurdle rate is the rate of return a firm has to offer finance providers to induce them to buy and hold financial security. (Arnold,2007). This is also known as cost of capital or weighted average cost of capital. The returns offered by alternative securities with the same risk influences the hurdle rate.
Larry Stone would need to estimate the firm’s hurdle rate because the firm would have to earn a minimum rate of return to cover all the costs generated from funds used to finance investment. The firm’s bonds and stocks would not be sold if the firm does not a minimum rate that covers their cost of generating funds.
When there are differences in the degree of risk between the firm and its divisions then it is not justifiable to use the firm’s weighted average cost of capital as the divisional cost of capital.
We use the company's cost of capital to value new assets which have the same risk as the old ones. If the company is acquiring new assets whose risk is more or less than the risk of the existing assets then the capital required to finance(fund) the new assets will have a different cost of capital as investors demand a return based on the risk to their investment.
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