Rainman Corporation is a multidivisional producer of home appliances, industrial equipment, and ceramic coating materials with high strength and resistance to high temperatures. The company also has a division which is active in real estate development. Because of the nature of the various product lines, the company was divided into four separate divisions in 2000: (1) The Home Products Division, (2) The Equipment Manufacturing Division, (3) The Ceramic Coatings Division, and (4) The Residential Real Estate Division. This arrangement has worked reasonably well, but frictions have developed among divisions, and Rainmans stock 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 Mr Rayyan, the firms financial vice president, to identify problems and to recommend ways to eliminate them. Rayyan 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. It seems the company does not formally incorporate differential risk into project evaluations. The current capital budgeting process works as follows:

1. The corporate treasurer develops the companys weighted average cost of capital.
2. Each division estimates the projected cash inflows and outflows for each potential project, and these project data are entered into computerized capital budgeting system, which calculate each projects NPV, IRR and payback.
3. If a projects NPV is positive and large, if IRR is at least 3 percentage points above the companys cost of capital, and if the payback is four years or less, then the project will usually be accepted. Otherwise, the project will almost always be rejected.
4. Projects with NPVs close to zero, IRR close to the cost of capital and paybacks in the five-to-seven year range are considered marginal. Whether to accept or reject these projects, it depends on the managements confidence in the cash flow forecasts, on the projects long-run strategic effects on the firm, and on the availability of capital.

Although everyone agrees that an average project in Ceramic Coatings Division is substantially riskier than an average project in the Home Products Division, no explicit allowance is made for this differential risk. As a result, substantially more capital has been invested in the Ceramic Coatings Division because high-risk projects typically offer high returns. Rayyan recognized that such problems are inherent in an informal risk-adjustment process. Also, his assistant, Linda, a recent MBA graduate, concluded in her annual review of the companys budgeting process with two strong recommendations: (1) that project risk be given more formal consideration in the capital budgeting process, and (2) the idea of different cost of capital for different divisions to be investigated. Rayyan realized the need for some sort of formal risk evaluation system and this requires cooperation of many managers from all parts of the organization.

Rayyan set up a team to study the question of risk-adjusted divisional hurdle rate. The corporate treasurer, the capital budgeting director and the four divisional controllers are all included in the team. After several discussions, the management agrees that the firms risk, as seen by well-diversified investors, is the key determinant of its cost of equity capital, and they also agrees that investors estimate risk by a stocks relative volatility to the market return as measured by its beta coefficient. Linda then sets up the following table:

Division	Percentage of Corporate Assets	Estimated Divisional Beta
Home Products	0.50	0.65
Equipment Manufacturing	0.30	1.05
Ceramic Coatings	0.10	1.95
Real Estate	0.10	0.6
	1.00

Linda used these divisional betas to set basic risk-adjusted cost of capital for each division. First she estimated the cost of equity using the CAPM. The companys cost of equity will be determined using the current Treasury bill rate of 8 percent and the expected market return of 13.5 percent.

Under current procedures, this cost of equity would be averages in with debt to find the companys cost of capital, which would then be used to evaluate all projects in all divisions. However, Linda feels that the data clearly show that each divisions cost of equity differs from companys cost.

The next question that Linda must consider is capital structure: Should different divisions be assigned different capital structures and debt costs, or should they be assigned the corporate average? If different, how should they be derived? Linda decided to use the companys target capital structure of 45 percent debt and 55 percent equity for each divisions capital structure. In addition, the companys before-tax cost of debt is 11 percent with a corporate income tax of 25 percent.

When she presented her initial ideas at the committee meeting, the representative from the Real Estate Division voices as strong objection. He is displeased with the fact that uniform capital structure of 45 percent debt and 55 percent equity was proposed. He argued that the firms in real estate industry averaged close to 75 percent debt, even the most conservative ones used about 60 percent debt. The capital budgeting manager backed the Real Estate Division controllers view, noting the problem in setting divisional hurdle rate. The corporate treasurer suggested that some problems have been brought on in part by an overexpansion resulting from the use of hurdle rates that are unrealistically low.

After the meeting, Linda 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. Still, she believes that her suggestion in the meeting was right on track, and she plans to add to the recommendation by suggesting that divisional 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 of 1.2 times the divisional rate, average projects would be evaluated at the divisional rate and low-risk projects would be evaluated at a hurdle rate of 0.9 times the divisional rate.

In drafting her final conclusions, Linda remains convinced that capital budgeting must involve judgement as well as quantitative analyses. Lindas report emphasizes that the current general procedure should be retained, but that the quantitative inputs used in the final decision would be better if differential risk-adjusted discount rated were used.

REQUIRED

1. Describe the main issue of the case.

2. Calculate the companys cost of capital as developed by the corporate treasurer?

3. Estimate the risk-adjusted divisional hurdle rates for each division, assuming that all divisions use a 45 percent debt ratio for this purpose.

4. Now assume that, within divisions, 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 division?

5. Do you agree to use the companys target capital structure of 45 percent debt and 55 percent equity as each divisions capital structure as recommended by Linda? Explain your answer.

6. Suppose Ceramic Coatings Division has an exceptionally large number of projects whose returns exceed the risk-adjusted hurdle rates, so its growth substantially exceeds the company average. What effect would this have, over time, on Rainmans corporate beta and on the overall cost of capital?

7. One problem with a market risk analysis relates to differences in reported beta coefficients. Explain why reported historical beta values are so inconsistent. Do historical betas provide good measures of the future riskiness of firms?