Randolph Corporation – Cost of Capital

1. Introduction

The Randolph Corporation is composed out of four different divisions – the Home Products, the Equipment Manufacturing, the Ceramic Costing and the Real Estate division. Due to the different nature of these divisions, frictions have developed and the company management recognizes poor performance of the company’s stock in comparison to its industry. To improve the company’s performance, a study group was assigned to investigate whether a change in hurdle rates, to a divisional or project based rate, will influence performance positively and how risk adjustments can be taken to ensure sufficient financing for projects. This report examines the processes and issues evolving from capital budget decisions.

The report contains analysis of the firm’s current capital distribution to its divisions on the basis of hurdle rates. Several analyses are performed, evaluating the effects of changes in the capital budgeting decisions and capital structuring. Moreover, the report provides recommendations for improvements for the capital budgeting and firm capital structuring.

2. Estimation of Hurdle Rates for Divisions (Q. 1-4)

For calculating the company’s overall hurdle rate, first the individual divisional hurdle rates have to be calculated. As projects can be funded through debt and equity, the Weighted Average Cost of Capital (WACC) is used to estimate a required rate for the hurdle rate. To simplify the analysis, for each division a debt ratio of 45 percent is assumed even this might differ significantly in reality. For the calculation of the required return on equity using the Capital Asset Pricing Model (CAPM) the betas of each divisions as well as the market return of 13,5% are needed. Using the debt and equity ratios, the return on equity, the return on debt and the tax rate, the divisional weighted average cost of capital rates were calculated. (Appendix 1). As the ratios and the cost of debt were equal for all divisions, the divisions with higher...