Reference no: EM13381787

Question

It is common for organisations which raise finance at the corporate level and then allocate that finance to projects throughout the organisation, to use the weighted average cost of capital as the required or hurdle rate in determining fund allocation. This approach is appropriate only in very specific circumstances. Particular frictions and issues may arise where an organisation is arranged into semi-autonomous Departments with each Department being involved in activities with disparate levels of risk.

Examples of the issues include:

 (a) The use of a firm wide cut off rate in which no explicit allowance is made for differential risk may well result in more capital being invested in the more risky department (and in riskier projects from all departments), than otherwise would have occurred, because high-risk projects typically offer high returns. The question that arises here is whether hurdle rates be established for each department, for each product line within a department, or on an individual project basis. A related issue is how to measure the risk.

 (b) Another issue that arises in this regard is that of differential debt capacity. This issue is important because some departments need to use more debt so as to compete effectively with other firms that operate in the same industry. Some department managers may well argue that they could remain competitive only if their departments could follow industry practice for capital structure when calculating hurdle rates. Thus the question arises as to whether different departments should be assigned different capital structures and debt costs or whether they should be assigned the corporate average. If different capital structures are to be used, how should they be derived? What interest rate should be used for debt?  How should departmental equity costs be adjusted to reflect varying capital structures?

Mellicious Ltd

Mellicious Ltd is a multidepartmental producer of (1) abrasive products, especially high-quality electric sanders and sandpaper for home use, (2) industrial grinders and sharpeners, and (3) coated ceramics used in aerospace and other industries that require surface bonding agents with high strength and resistance to high temperatures. The company also has a department which is active in real estate development. This department was started several years ago, when a large tract of land just west of Melbourne, Victoria, which Mellicious had acquired for its industrial potential many years ago, became valuable for Real Estate development. Because of the nature of the various product lines, the company was divided into four separate departments in 2000: the Products Department, the Equipment Department, the Coatings Department, and the Real Estate Department. This arrangement has worked reasonably well, but frictions have developed among the departments, and Mellicious's share price has not performed as well as that of others in the industry.

A special committee was appointed by the board of directors to evaluate this situation. The committee has asked all senior executives, including Tony Scarff, the firm's financial vice president, to identify problems and then to recommend ways to eliminate them.

Scarff found numerous small ways in which financial operations could be changed for the better, but only one area presented a major problem - the financial planning process and, specifically, the way risk is taken into consideration in this process. Currently, Mellicious does not formally incorporate differential risk into project evaluations.

The capital budgeting process works like this:

1. A corporate hurdle rate is developed by the corporate treasurer.

2. Projected cash inflows and outflows are estimated for each potential project by each Department, and these project data are entered into the computerized capital budgeting system, which then calculates each project's NPV, IRR, MIRR, and payback.

3. If a project's NPV is positive and large, if its IRR and MIRR are at least 3 percentage points above the corporate hurdle rate, and if its payback is four years or less, then the project will usually be accepted. On the other hand, if the NPV is negative, if the IRR and MIRR are well below the corporate hurdle rate, and if the payback period is long (eight years or more), the project will almost always be rejected.

4. Projects with NPVs close to zero, IRRs and MIRRs close to the corporate hurdle rate, and paybacks in the five-to-seven-year range are considered marginal. These projects are accepted or rejected depending on management's confidence in the cash flow forecasts, on the project's long-run, strategic effects on the firm, and on the availability of capital.

Although everyone agrees that an average project in the Coatings Department is substantially riskier than an average project in the Products Department, no explicit allowance is made for this differential risk. As a result, substantially more capital has been invested in the Coatings Department (and in riskier projects from all Departments), than otherwise would have occurred, because high-risk projects typically offer high returns. Scarff recognizes that such problems are inherent in an informal risk-adjustment process. Also, his assistant, Wendy Wu, a University of Ballarat graduate recently concluded her annual review of the company's budgeting process with two strong recommendations:

1. That project risk be given more formal consideration in the capital budgeting process, and

2. That the idea of different hurdle rates for different departments be investigated.

Scarff appreciates the need for some sort of formal risk evaluation system, but he is afraid that top management will resist such an approach unless he can document why so radical a departure from past practices is necessary and also show how not using such procedures has hurt the company in the past. The job of proving the need for, and then designing a risk evaluation system will not be easy - it will require the co-operation of many managers from all parts of the organization

With the annual budget completed and no urgent problems facing him, Scarff set up a team to study the question of risk-adjusted hurdle rates. Betty Bu, the corporate treasurer, Jim White, the corporate capital budgeting director, and the four departmental controllers comprised the study group.

Wendy Wu was also assigned to the study group and was asked to research the following questions, plus any others she regarded as important:

1. Should hurdle rates be established for each Department, for each product line within a Department, or on an individual project basis?

2. How should project risk be measured?

3. How should capital structure, or debt capacity, be handled? This issue is important because the Real Estate Department manager, Emmit Jones, has been complaining that he needs to use more debt if he is to compete effectively with other firms in the real estate development business.

Wu decided that a reasonable place to start her inquiry was to focus on the concept of market risk which she had studied as a student. After several discussions, she found that Mellicious's senior management agreed that the firm's risk, as seen by well-diversified investors, is the key determinant of its cost of equity capital. The senior managers also agreed that investors estimate risk, in large part although not exclusively, by the share price's relative volatility as measured by its beta coefficient. Wu had earlier conducted a study of the determinants of Mellicious's beta and had concluded that the corporate beta is a weighted average of the betas that the four departments would have if they were operated as separate firms.  Wu then set up the following table:

Percentage of       Estimated

   Department        Corporate Assets      Departmental Beta    Product

   Real Estate        0.10      0.60       0.060

   Coatings          0.10      1.95       0.195

   Equipment         0.30      1.05       0.315

   Products          0.50      0.65       0.325

  1.00

   Weighted average corporate beta            = 0.895»0.90.

In estimating the Departmental betas, Wu:

1. Examined the betas for publicly held real estate, abrasives, general manufacturing, and special coatings companies, and

2. Looked at the volatility of earnings in each Department vis-a-vis earnings on the ASX All Ordinaries index.

The betas as estimated by both of these methods for each department, were then averaged, and this average was used as the departmental beta reported in the tabulation. The weighted average of the departmental betas, 0.9, is quite close to Mellicious's beta coefficient as reported by leading brokerage houses.

Wendy Wu then used these departmental betas to set basic risk-adjusted costs of capital for each department. First, she estimated the required rate of return on equity, k_e, by using the Security Market Line (SML) equation:

k_e = k_RF = (k_M-k_RF)b

Here k_M is the return on an "average" share, k_RF is the riskless rate, b is the share's (or department's) beta coefficient, and the term (k_M - k_RF)b is the share's (or department's) risk premium above the risk-free rate.  Using the current Treasury bond rate as the riskless rate, k_RF = 8.0%, and the Goodman Saks estimate of the long-run return on the market, k_M = 13.5%, Wu concluded that the corporate cost of equity for Mellicious is 13.0 percent:

k_e   = 8.0% + (13.5% - 8.0%)0.9

= 8.0% + (5.5%)0 9

= 12.95%    » 13.0%

Under current procedures, this 13 percent would be averaged in with debt to find the corporate weighted average cost of capital (WACC), which would then be used to evaluate all projects in all departments. However, Wu feels that the data clearly show that each department's cost of equity differs from the 13.0 percent corporate cost, depending on the department's own beta.

The next question Wu must consider is capital structure: Should different departments be assigned different capital structures and debt costs or should they be assigned the corporate average? If different capital structures are to be used, how should they be derived?  What interest rate should be used for debt? How should departmental equity costs be adjusted to reflect varying capital structures?

Wu decided to use the corporate target capital structure of 45 percent debt for each Department for the following reasons

1. Her old finance lecturer argued that the WACC is not very sensitive to capital structure over a fairly wide range of debt ratios, therefore, the issue is not as critical as it might first appear.

2. If a department were assigned a high debt ratio, its costs of debt and equity would rise, and this would tend to offset the greater use of lower-cost debt capital.

3. Wu reasoned that she was already going to have a hard time persuading management to accept multiple hurdle rates, and the simpler her approach, the greater her chance of success.

Now that she has cost-of-equity estimates for each department, as well as the appropriate capital structure weights, Wu can calculate benchmark hurdle rates for each department. Mellicious's before-tax cost of debt is 11.0 percent and the corporate tax rate is 40 percent.

When Wu presented her initial ideas at the first committee meeting, the representative from the Real Estate Department voiced a strong objection. Debra Scarff, the department's vice president, was displeased with the fact that a uniform capital structure of 45 percent debt was proposed. She argued that firms in the real estate industry averaged close to 75 percent debt - even the most conservative ones used about 60 percent debt-and, based on the conservative firms' bond ratings, their before-tax cost of debt averaged only 10.5 percent, or 50 basis points below Mellicious's overall cost of debt.

Their cost of equity, using beta coefficients provided by several financial services companies, is about 13.0 percent, which, assuming a tax rate of 40 percent, results in a hurdle rate of about 9.0 percent:

WACC   = w_d(k_d)(1- T)   +  w_e(k_e)

  = 0.6(10.5%)(0.6)   +   0.4(13.0%)

  = 8.98% » 9.0%

Scarff argued that if she is forced to use a higher hurdle rate while competing firms use 9.0 percent, Mellicious will lose ground in the real estate business. Jim White backed her up, noting that he had recently attended a conference at which a case study involving Continental Foods' problem in setting departmental hurdle rates was used. The restaurant industry tends to have debt ratios of about 70 percent, as compared to 38 percent for the major departments of Continental Foods. Continental decided to use a 70 percent debt ratio for its restaurant Department, compared to 40 percent for its frozen foods department, so that comparability with stand-alone competitors could be achieved. Other attendees had pointed out that Zenith Steel Corporation's Equipment Lease Financing department also has a high debt ratio (about 80 percent debt, as opposed to 42 percent for its other departments). In both situations, the companies indicated that they could remain competitive only if their departments could follow industry practice for capital structure when calculating hurdle rates.

When White finished, Betty Bu noted that both the restaurant and equipment leasing industries have recently been experiencing financial difficulties. Regarding Continental, Hale cited the following quote from The Wall Street Journal:

Continental Foods disclosed some more bad news about its earnings, and it received some bad news itself from a major credit service, which reduced the rating onthe food processor's debentures  ....net income fell 22% while sales rose 18%  .... debentures were downgraded to Single-A-plus from double A because of the "continuing deterioration in earnings and fixed charge coverage."

Hale then suggested that these problems might have been brought on in part by an overexpansion resulting from the use of hurdle rates that were unrealistically low. Others agreed with her point, but no conclusions were reached at the meeting; the study group decided to defer action until Wu's report was finalized.

After the meeting, Wu had extended discussions with operating personnel regarding various ways of accounting for individual project risk. She concluded that any system would necessarily be somewhat arbitrary and imprecise. Most individual projects are parts of larger processes, and the results of a given capital project are highly sensitive to market and production conditions for the product. Still, experienced operating personnel admitted that they are more confident about the projected cash flows from some projects than from others, and they recognized that some projects are simply riskier than others. Also, White reported that some operating personnel have better "track records" in forecasting cash flows than others have, and White takes this fact into account in his own assessment of project risk.

For large projects, generally those involving entirely new technologies or product lines, Wendy Wu believes that Monte Carlo simulation or scenario analysis should be used to generate distributions of rates of return. Probabilities would be assigned to sales prices, sales quantity, and so on, and both an expected rate of return and the standard deviation of returns would be developed. However, the vast majority of proposed capital projects would not be subjected to such analyses.

Wu feels that the costs would outweigh the benefits of such approaches for smaller projects, especially in view of the highly subjective nature of the estimation process that would have to be used for the probability data.

Still, Wu recommended that departmental managers be required to classify projects into one of three groups: high risk, average risk, and low risk. Risky projects would be evaluated at a hurdle rate 1.2 times the departmental rate; average projects would be evaluated at the departmental rate; and low-risk projects would be evaluated at a hurdle rate 0.9 times the departmental rate. When this was discussed at the next study group meeting, the members agreed that the recommended procedure was arbitrary, but most felt that it would be superior to what was currently being done. Moreover, they could suggest no better procedure.

In drafting her final conclusions, Wu remained convinced that capital budgeting must involve judgment as well as quantitative analyses. At present, the capital budgeting process is as follows:

1. One hurdle rate is used throughout the entire corporation;

2. NPVs, IRRs, MIRRs, and paybacks are calculated; and

3. These quantitative data are used, along with such qualitative factors as "what the project does for our strategic position in the market," in making the final "accept, reject, or defer" decision.

Wu's report emphasized that this general procedure should be retained, but that the quantitative inputs used in the final decision would be better if differential risk-adjusted discount rates were used.

The day before her final report was due, Wu received a call for jury duty. She had avoided serving the last two times she was called, so there was no way out this time - it was jury duty or jail for contempt of court. Assume that you have been assigned to take over the task of completing the report and defending it before the study group. Wu did leave you with the following list of questions to help you complete the task. She also informed you that Tony Scarff, the financial VP, was thinking of giving you a significant promotion, but your chances for the promotion will be ruined if you do not do a good job writing up the report and then answering questions about it.

Required

1. Estimate the Departmental hurdle rates for each department. Assume that all Departments use a 45 percent debt ratio for this purpose.

2. Now assume that, within departments, projects are identified as being high risk, average risk, or low risk. What hurdle rates would be assigned to projects in those risk categories within each department?

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 Coatings Department 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 Mellicious's corporate beta and on the overall cost of capital?  (Assume that the aggregate risk of the department remains unchanged.)

5. Suppose that, despite the higher cost of capital for risky projects (1.2 times departmental cost), the Equipment Department 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?

6. Do you agree with Wu on the capital structure issue?  How would your thinking be affected if:

(a) each department raised its own debt, that is, if the departments were set up as wholly owned subsidiaries, which then issued their own debt (in fact, Mellicious raises debt capital at the corporate level, and funds are then made available by headquarters to the various departments);

(b) departments issued their own debt, but the corporation guaranteed the Departmental debt; or

(c) all debt was issued by the corporation (which is actually the case).