Case 6

Case 6- Divisional Hurdle Rates

1. WACC/Hurdle Rate

Real Estate: 9.19%

Ceramic Coatings: 10.24%

Equipment Manufacturing: 10.55%

Home Products: 9.34%

Hurdle rate per division

2. High Risk: Ceramic Costings

Average Risk: Equip. Manu.

Low Risk: Real Estate and Home Products

3. How comfortable are you with the 1.2 and 0.9 project risk-adjustment factors? Is there a theoretical foundation for the size of these adjustments?

4. Suppose the Ceramic Coatings Division has an exceptionally large number of projects

whose returns exceed the risk-adjusted hurdle rates, so its growth rate substantially exceeds the corporate average. What effect would this have, over time, on Randolph’s corporate beta and on the overall cost of capital? (Assume that the aggregate risk of the division remains unchanged.)

The effect this would have, over time, on Randolph’s corporate beta and on the overall cost of capital, assuming that the aggregate risk of the division remains unchanged, is this means that the value of assets in this division will grow faster than the remainder of the company so neither the beta and the overall cost of capital changes over time. As the asset beta increases, the equity beta will increase also. However as the value of assets increases, the leverage will decrease -this will cause a partially offsetting effect, however for normal levels of debt, the equity beta will increase.

5. Suppose that, despite the higher cost of capital for risky projects (1.2 times divisional cost), the Equipment Manufacturing Division made relatively heavy investments in projects deemed to be more risky than average. What effect would this have on the firm’s corporate beta and overall cost of capital? How long would it take for the effects of these relatively risky investments to show up in the corporate beta as reported by brokers and investment advisory services?

In an all-equity firm, the decision to invest in higher-beta projects would tend to drive up the firm...