Capital Structure Theory and Hurdle Rates

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Capital Structure TheoryandHurdle Rates
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Capital StructureTraditional Approach
Cost of Equity
Cost of Capital
Cost of Debt
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Modigliani and Miller(No Taxes)
Cost of Equity
Cost of Capital
Cost of Debt
4
Modigliani and Miller Revised
Cost of Equity
Cost of Capital With Taxes Bankruptcy Costs
Cost of Capital With Taxes
Cost of Debt
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Capitalization Ratio
Industry
Hershey Foods Corporation
This capitalization ration is calculated as the
book values of (Short-Term Debt Long-Term
Debt) / (Short-Term Debt Long-Term Debt
Equity)
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Capitalization ratio - 1998
This capitalization ration is calculated as the
book values of (Short-Term Debt Long-Term
Debt) / (Short-Term Debt Long-Term Debt
Equity)
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Cost of CapitalMarket Weights
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Cost of Capital Review
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Hurdle Rates

• Consider Risk vs. Return
• Analogous to Mutual Fund Scoring
• Cost of Capital Based
• Aligned to Project Classifications
• Integral to Capital Investment Process

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Overview and Agenda

• Hersheys Previous Capital Expenditure Structure
• Determining Hurdle Rates
• Hersheys Revised Approach
• Approaches of Lehigh Valley Firms
• 14 Unidentified Firms

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Hersheys Previous Capital Expenditure Structure

• Divisional Based
• Project Categories
• Evaluated only Profit Adding Projects
• Hurdle Rates
• Cost of Capital
• Added Increment for Support Projects
• Double the Cost of Capital

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Hersheys Previous Capital Expenditure Structure

• Shortcomings / Opportunities
• Institutionalized Accepting Inferior Projects
• Favored High Return / High Risk Projects
• Diminished Hersheys Growth
• Biased Decisions to Acquired
• Increment for Support Projects was unstable,
  self-perpetuating, and non-convergent

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Capital Expenditure Revisions

• Overall Process
• Capital Project Structure
• Hurdle Rate Approach

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Divisional Hurdle Rate Approaches

• Pure Play Technique
• Publicly Reported Segment Comparison
• Accounting/Earnings Approach
• Spanning Technique
• Probabilistic Adjusted Cash Flow
• Gup/Norwood Adjustment

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Pure Play Technique

• Divisional Hurdle Rates
• Search for Publicly Traded, Single-Line Companies
• Use Pure Plays Beta (CAPM) and Capital Structure
• Limitation on Available Pure Plays

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Publicly Reported Segment Comparison

• Linear Programming Approach
• Uses Segment Reporting from Annual Report
• Estimates a Divisional Beta
• Limitation on Segment Reporting

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Spanning Technique

• Replicates Divisions Cash Flow using
  Publicly-Traded Investment Portfolios
• Creates 1,000 or more Portfolios
• Observes Their Average Beta
• Limitation on Quality of Answers
• Non-Sensical Relationships
• Wide Variances

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Probabilistic Adjusted Cash Flow

• Attach Probabilities to Achieving Cash Flow
  Performance
• Difficult to Develop Base Cash Flows
• Almost Impossible to Develop Multiple Cash Flow
  Scenarios with Probabilities
• Managements Comprehension and Acceptance

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Gup/Norwood Adjustment

• No Divisional Pure Plays or Competitor Segment
  Data Available
• Systematic Approach That Attempts to Quantify
  Divisional Risk Premium
• Objective Risk Based on Actual vs. Plan
  Comparisons and Growth
• Subjective Risk Based on Managements Assessment
  of 15-25 Criteria

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Revised Capital Expenditure Structure

• Shift from Engineering to Finance
• Recognized That Risk Was Differentiated by
  Project Category
• Revisited and Reevaluated Project Categories
• Evaluated Hurdle Rate Requirements

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Hurdle Rate Requirements
Return
1
3
4
2
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Project Classifications

• Conventional Capital Expenditures
• Cost Savings
• Capacity Expansion
• New Products
• Existing Product, New Market
• New Product, Existing Market
• New Product, New Market
• Research Development
• Applied Research
• Basic Research

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Hurdle Rate Requirements
Return
Return
Risk
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Approaches ofLehigh Valley Firms

• One-Credit Course, Financial Valuation of
  Business Decisions
• Capital Budgeting and Hurdle Rate Assignment -
  55 of Seminar Grade
• Pick a Company and Interview Executives
• Document Capital Budgeting Phases
• Document Cost of Capital / Hurdle Rates
• 14 Companies Documented to Varying Degrees

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Lehigh Valley Firms Results

• Tremendous Learning Experience
• Solidified Seminar Concepts
• Case Study Usable Results
• Project Categories
• Capital Budgeting Techniques
• Development of Cost of Capital and Hurdle Rates
• Other Interesting Observations

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Elaborate Project Categories
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Other Project Categories

• Company 5
• No Specifics Left to Division
• Must Enhance Strategic Objectives
• gt10 Sales Growth
• Improve SGA
• RD Inv - 11 Sales
• Double ROA to 10
• Reduce Tax Rate 4

• Company 6
• Business Necessary
• No Justification
• Business Improvement
• Always Justified

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Integrated Example
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Capital Evaluation Techniques
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Cost of Capital Techniques
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Other CommentsLehigh Valley Firms

• Monte Carlo Simulation to Be Introduced in Next 3
  Years
• Hospital Cautioned with a Balance to Serve the
  Community
• Analysis Application Starting on Projects from
  6,000 to 250,000
• Many Documented Process and Authorization Levels