Response to the following problem:
Estimate the Departmental hurdle rates for each department. Assume that all Departments use a 45 percent debt ratio for this purpose. 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?
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?
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.) 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?
Do you agree with Wu on the capital structure issue? How would your thinking be affected if:
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); departments issued their own debt, but the corporation guaranteed the Departmental debt; or all debt was issued by the corporation (which is actually the case).