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 divisions with each division 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 division (and in riskier projects from all divisions), 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 division, for each product line within a division, 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 divisions need to use more debt so as to compete effectively with other firms that operate in the same industry. Some division managers may well argue that they could remain competitive only if their divisions could follow industry practice for capital structure when calculating hurdle rates. Thus the question arises as to whether different divisions 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 divisional equity costs be adjusted to reflect varying capital structures?
There are three types of protect risk that can be considered,
Required
a) What type of risk do we adjust for?
b) Which of these risks should we be interested in?
c) How do we measure the risk and incorporate it into the analysis.