Divisional Hurdle Rates - Randolph Corporation

Topics: Weighted average cost of capital, Finance, Risk Pages: 6 (1878 words) Published: November 26, 2012
The Randolph Corporation is a multidivisional producer of electric sanders, sandpaper, industrial grinders and sharpeners, and coated ceramics. The Corporation also has a real estate development division. The diverse product lines of the company divide the corporation into four divisions, namely, real estate, ceramic coatings, equipment manufacturing and home products. The Randolph Corporation Stock performed below expectations recently, when compared to other player in the industry. The company’s main problem is believed to lie in the financial planning processes and in the risk consideration. To tackle these problems the assistant to the firm’s vice president suggests a target capital structure of 45% debt in every division and differing hurdle rated for low, average, and high risk projects.

This paper critically reviews the different suggested measures and finally proposes measures that should be taken to improve the performance of the Randolph Corporation.

Divisional Hurdle Rates
To estimate the hurdle rates for every division of the Randolph Corporation that weighted average cost of capital (WACC) have to be calculated for every division. To apply the formula of the WACC the costs of equity have to be known. The cost of equity can be determined through the Capital Asset Pricing Model (CAPM). The results for every division’s equity cost and the computation of the hurdle rates can be seen in the Appendix. The divisions with higher risk have higher weighted average cost of capital.

WACC/Hurdle Rate
Real Estate9.19%
Ceramic Coatings10.24%
Equipment Manufacturing10.55%
Home Products9.34%
Fig. 1: Hurdle rate per division

To account for different levels of risks between the company’s projects the assistant of the vice president suggested an inclusion of different levels of risk within every division’s capital budgeting procedure. Managers in the divisions are asked to classify projects as high, average or low risk. Rather risky projects will hereafter be evaluated at a hurdle rate of 1.2 multiplied by the divisional rate, projects of average risk are to be evaluated at just the divisional rate while low risk projects have a hurdle rate of 0.9 multiplied by the divisional rate. This produced the following rates, as shown in figure 2.

WACC/Hurdle Rate
Low RiskAverage RiskHigh Risk
Real Estate8.27%9.19%11.02%
Ceramic Coatings9.22%10.24%12.29%
Equipment Manufacturing9.49%10.55%12.66%
Home Products8.40%9.34%11.20%
Fig. 2: Hurdle rate per division and risk level

At this time the risk adjustment factors discussed here must be reviewed with a critical eye. Accoring to Brigham & Daves (2007), there is no theory that could serve as a foundation of justification for the size these risk-adjustment factors. The authors say that there is no specific value that can be assigned to accurately adjust for the risk and therefore determine higher or lower discount rates.

Corporate Beta & Cost of Capital
Taking a weighted average of the four divisional betas gives the overall corporate beta. The corporate beta is therefore affected by changes of the divisional weights and by changes of the individual beta of the particular divisions. The two following scenarios will illustrate this issue.

The Corporate beta increases if the ceramic coating division had a large number of projects with returns exceeding the risk adjusted hurdle rates. When the growth rate of the coatings division surpasses the overall corporate growth rate the division’s assets and thereby its weight will increase moving the corporate beta closer to the beta of the ceramic coatings division. Since the cost of equity rise with increases of beta, the larger corporate beta should also raise the corporate cost of capital (WACC). How strong such changes are to be is however determined by capital structure and weights on other departments.

The corporate beta also increases when the equipment manufacturing...
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