Caselet on Cost of Capital

You have recently been appointed as the chief manager of the finance division of GNR Corporation. GNR is a diversified company with three independent divisions: Metals, Real Estate and Finance. The company evaluates the performance of each division based on a common cost of capital which is the cost of capital to the company. Being a finance person, you are unable to appreciate the logic of a common hurdle rate when the business profiles and risks involved of the three divisions are so different. When you take up the matter with the corporate office, the wise men there decide to use your finance expertise to the companys advantage. They ask you to work out separate costs of equity and hurdle rates for each division and send the report for approval of the board. They also ask you to list out the various measures that can be adopted to mitigate risk. For the calculations you use the following details: Exhibit 1 containing the latest balance sheet of the company with division- wise break up figures for assets and loans. Exhibit 2 containing summarized financial statements and other details of three companies, Vajra Metals, Saheja Realty and Maxima Finance which are typical pure play companies with which the metals, real estate and finance divisions of GNR are respectively in active competition. The risk-free rate currently is 9 percent and the general view is that the market risk premium is 10 percent. The corporate tax rate of 30 percent is applicable to all the businesses. Exhibit 1 Balance Sheet of GNR Corporation Shareholders Funds Capital Reserves and surplus Loan Funds Term loan (12% interest) : Metals : Real estate : Finance : Working capital loan (15% interest) Metals : Real estate : Finance : Fixed Assets Metals : Real estate : Finance : 4000 Net Current Asset Metals : Real estate : Finance : 6000 900 5100 8200 2600 3800 1800 1800 800 400 600

2500 400 1200 900 1500 600 500 400

10000

10000

Exhibit 2 Financial Data for the three companies Vajra Metals Fixed assets Net current assets Share capital Reserves and Surplus Loan funds Revenues Net profit Equity beta 4300 1300 5600 1400 2600 1600 5600 7200 800 1.4 Saheja Realty 6800 800 7600 1300 3800 2500 7600 4000 500 0.9 Maxima Finance 2900 1700 4600 1000 1200 2400 4600 3200 300 0.80

You are required to answer the following questions. (1) What is the cost of equity applicable to the three divisions, viz, Metals, real estate, and finance? (2) What is the cut-off rate (cost of capital) applicable to the three divisions, viz, Metals, real estate, and finance?