Introduction
Randolph Corporation, a multidivisional company, has seen its stock underperform due to internal divisions and frictions.
In order to enhance Randolph’s financial situation and competitiveness, several questions must be addressed. Below, we will explore these questions individually.
Question 1: Determine the divisional hurdle rates, considering a 45% debt ratio.
Question 2: The task is to determine the hurdle rates for high risk, average risk, and low risk projects within each division. To calculate the divisional hurdle rates, the cost of capital (KS) needs to be reviewed using the CAPM formula.
Question 3: How can the 1.2 and the 0.9 risk adjustment factors be explained? Is there a theoretical foundation for it? In general, it is preferable to differentiate hurdle rates between projects with different types of risks. If all projects with different types of risk have the same hurdle rates, managers would likely choose the most risky project because of higher expected returns. This would also increase the divisional beta. Therefore, it is justified to distinguish hurdle rates based on the level of risk involved.
It is important for managers to consider projects with lower risk. However, it is uncertain if the adjustment factors should be precisely 0.9 or 1.2. Nonetheless, the difference between the adjustment factors should not be too large to avoid neglecting profitable projects or accepting unprofitable ones.
Question 4: The Ceramic Coatings division’s returns surpass the risk-adjusted hurdle rate, indicating a growth rate higher than the corporate average. What impact does this have on the corporate beta and the overall costs of capital?
When examining the weighted average corporate beta, it can be seen that it increases. If this higher beta is plugged into the CAPM formula, while keeping the other variables constant, the overall cost of capital will also increase. Question 5: The Equipment Manufacturing Division has made significant investments in high-risk projects. This will have an impact on the corporate beta and the overall cost of capital for the firm. It is uncertain how long it will take for these risky investments to reflect in the reported corporate beta.
Under the assumption of a strong form of market efficiency, the stock price and corporate beta promptly reflect all pertinent information. Similarly, in the case of semi-strong market efficiency, the disclosure of risky investments results in an immediate inclusion in the corporate beta.
Question 6: How would your thinking be affected if:
– Randolph raises debt at corporate level and makes funds available to the individual divisions?
– Divisions issued their own debt, guaranteed by the corporation?
– All debt was issued by the corporation (as in the actual situation)?
When Randolph raises debt at a corporate level and makes funds available to the individual divisions, the corporation can benefit from the lower average costs of debt than if divisions would have raised debts individually, due to diversification effects. In this situation, the different divisions can raise their individual amount of debt needed at a corporate cost of debt rate, making them more competitive compared to the actual situation.
If all divisions borrow at the corporate cost of debt rate, the Real Estate and Home Products division would have a higher cost of debt rate compared to the Ceramic Coatings Division and the Equipment Manufacturing Division because of their lower betas. Alternatively, if divisions raise their own debt guaranteed by the corporation at their own cost of debt, there would be a higher average cost of debt. However, this would allow for a more fair attribution of the cost of debt to individual divisions based on their level of debt, while retaining the benefits of individual debt levels for each division. In the current situation, these benefits are lost as the corporate management determines the level of debt for each division, which may not always be appropriate. Therefore, the least efficient outcome arises from the current situation.
Question 7: Why is there variability in reported beta values over time and are historical betas accurate indicators of future firm risk? A firm’s beta is influenced by both macro-economic factors and internal decisions. As mentioned in question 5, beta increases when a firm chooses to pursue higher-risk projects.
The firm’s beta can be influenced by macro-economic factors such as changes in interest rates, available technology, or inflation. As a result, reported beta values fluctuate over time and are based on past data. However, historical betas do not accurately predict a firm’s future riskiness due to the unpredictability of the future. Researching alternative measures to determine a firm’s future risk would be an interesting topic. Question 8: Can total risk analyses be used to establish divisional hurdle rates?
It is possible to assess the risk of projects through total risk analyses on a stand-alone basis in order to overcome the problems associated with beta analyses. Brigham, E. F. and Daves, P. R. (2004) explain that by observing the nature of the individual cash flow distribution and their correlations with each other, the projects’ stand-alone risk, which is the NPV probability distribution, can be examined. This can be done through sensitivity analysis, scenario analysis, or Monte Carlo Simulation. Once the stand-alone risk has been determined, an appropriate hurdle rate can be established.
If a project has a high volatility, the hurdle rate needs to be adjusted to it. Therefore, each project has its own hurdle rate.
Question 9 – Do you see any obvious conceptual problems with the company’s compensation program? – How would the compensation plan impact managers? And what does it mean for Randolph’s stock price? – Should Randolph modify its compensation plan or its capital budgeting procedures to align them more with each other and the goal of maximizing stock price?
Several conceptual problems arise when examining Randolph’s management incentive compensation plans. Firstly, the incentive compensation is based on accounting numbers, which are susceptible to manipulation, and on short-term sales growth. This likely leads to management actions that prioritize short-term goals and rely on boosting sales growth and earnings growth or ROE. However, shareholders also require and value long-term focused management decisions. ROE can easily be compromised by earnings management if a manager, for instance, sets various bad debt allowances.
Sometimes, sales growth boasting may not be beneficial for shareholders. The formula for managed value added (MVA) indicates that an increase in the sales growth rate can actually harm the corporation if it requires a significant amount of capital (Brigham et al., 2004). Additionally, when examining top executive compensation, it becomes clear that their pay is dependent on the performance of divisional managers. This means they receive incentives for work that does not necessarily reflect their own contributions.
According to Kravitz, it is suggested that the corporation should implement multiple hurdle rates instead of just one. These hurdle rates would vary among divisions and also depending on the risk level of the project. By using these hurdle rates to evaluate new projects, managers would also take into account low risk projects with lower expected returns instead of relying solely on high-risk projects to boost earnings. This approach would result in accepting a greater number of lower risk projects due to the differentiation based on project risk.
Implementing hurdle rates would reduce corporate risk and benefit shareholders. However, the compensation plan may encourage managers to obscure results and prioritize increasing sales growth, earnings, and ROE to receive higher compensation. These actions are not in shareholders’ best interests. Kravitz’s recommendations should be followed to ensure fair compensation for divisional managers.
As previously mentioned, implementing this approach could reduce the risk to the entire corporation and protect the interests of its shareholders. Additionally, it is recommended that the compensation plan be modified in terms of duration. Calculating the average compensation ratios from the past five years would incentivize managers to prioritize long-term goals. Ultimately, this adjustment would align with the shareholders’ best interests.
Reference List:
- Brigham, E. F, Daves, P. R. (2004), Intermediate financial management. USA: Thomson, South Western
