UNIVERSITI UTARA MALAYSIA

OTHMAN YEOP ABDULLAH GRADUATE

SCHOOL OF BUSINESS (OYAGSB)
A192

CORPORATE FINANCIAL MANAGEMENT

(BWFF5013)
GROUP ASSIGNMENT 2

CASE STUDY OF RAINMAN CORPORATION

Written by:

MUHAMAD FITRI BIN SHAHIRAN

(826315)
MIRZAN MOHIDEEN BATHUSHA
(826582)
ABDIKARIN AHMED ABDI
(826386)

Lecturer:
ASOCIATE. PROF. DR. ROHANI BT MD RUS
1. Describe the main issue of the case

 Firstly, the cost of equity differs from the company’s costs. Secondly, assigned

of different capital structure and debt costs. Thirdly, the confirmation of 75%

debt of Real Estate industry and conservatively 60% debt. Then, to recognize

and decide with the basis of 3 group projects of high, average, and low risk,

and then, how to implement quantitative analysis that is better for differential

risk-adjusted rate.

 Although it had been divided into 4 separate Divisions (The Home Product

Division, The Equipment Manufacturing Division, The Ceramic Coating

Division, and The Residential Real Estate Division), there were frictions

regarding RAINMAN’s stock that had not performed as good as other within

industry.

 The one and only area that presented a major problem of the stated company’s

issue was in the Financial Planning Process, in which specifically towards

the appropriate way of how the risk was taken into company’s main

consideration to handle and overcome the current issue, said Rayyan (the

Firm’s Financial Vice President). Rayyan added, “It seems that the company

doesn’t formally incorporate its differential risk into its project evaluation”

 Additionally, based on Rayyan’s conformation, there was inherent problem of

informal risk-adjustment process where there were more capital that had been

invested in the Ceramic Coatings Division along with the principle of high-
 risk project typically would offer high return for the company. Then, it was

considered and realized that a certain system of formal risk evaluation was

potentially required by the company, in which within this circumstance it as

well required good cooperation of many managers from all parts of the

organization.

2. Calculate the company’s cost of capital as developed by the corporate

treasurer?

 Current Treasury – bill Rate (Rf) = 8 %

 Expected Market Return (Rm) = 13.5 %

 Cost of Equity (using CAPM) = Rf + β x (Rm – Rf)

o Home = 0.08 + 0.65 x (0.135 – 0.08 ) = 0.1158 @ 11.58%

o Equipment = 0.08 + 1.05 x (0.135 – 0.08) = 0.1378 @ 13.78%

o Ceramic = 0.08 + 1.95 x (0.135 – 0.08) = 0.1873 @ 18.73%

o Real Estate = 0.08 + 0.60 x (0.135 – 0.08) = 0.1130 @ 11.30%

Company's Cost of Capital

Estimated
Divisions Capital Structure (A) Cost of Equity (B) WACC (A x B)
Beta

Home 0.65 0.5 0.1158 0.058

 Equip 1.05 0.3 0.1378 0.041
Ceramic 1.95 0.1 0.1873 0.019
Real Estate 0.60 0.1 0.1130 0.011

Risk-adjusted Weighted Cost of Capital 12.93%

3. Estimate the risk-adjusted divisional hurdle rates for each division, assuming

that all divisions use a 45 percent debt ratio for this purpose.

*Cost of Debt (after Tax) = 11% x (1 – 25%) = 8,25%

*Hurdle Rates per Division = Cost of Debt’s WACC + Division’s WACC

 Risk-adjusted Divisional Hurdle Rates

Capital Structure Cost of Capital WACC

Divisions (A) (B) (A x B) Hurdle Rates

per Division
*Cost of Debt 0.45 0.08250 0.037
*Cost of Equity 0.55 0.12927 0.071
Home 0.55 0.05790 0.032 6.90%
Equip 0.55 0.04134 0.023 5.99%
Ceramic 0.55 0.01873 0.010 4.74%
Real Estate 0.55 0.01130 0.006 4.33%
4. Now assume that, within divisions, 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 division?

Division: Home products

Re = Rf + βε * (Rm – Rf)

= 0.08 + 0.65 (0.135 – 0.08)

= 0.08 + 0.65 (0.055)

= 0.08 + 0.03575

= 11.575 %

Hurdle rates per division = cost of debt’s WACC + Division’s WACC

= 0.037 + 0.032

= 0.069

= 6.9% * 0.9

= 6.21 %

Since home products beta is below than 1, we assume it is a low risk project. It will be

evaluate using 0.9 times divisional rate

Division: Equipment Manufacturing

Re = Rf + βε * (Rm – Rf)

= 0.08 + 1.05 (0.135 – 0.08)

= 0.08 + 1.05 (0.055)

= 0.08 + 0.05775
 = 13.775 %

Hurdle rates per division = cost of debt’s WACC + Division’s WACC

= 0.037 + 0.02273

= 0.05973

= 5.973%

Since home products beta is slightly more than 1, we assume it is an average risk

project. It will be evaluate using its own divisional rate.

Division: Ceramic Coatings

Re = Rf + βε * (Rm – Rf)

= 0.08 + 1.95 ( 0.135 – 0.08)

= 0.08 + 1.95 ( 0.055)

= 0.08 + 0.05775

= 18.725 %

Hurdle rates per division = cost of debt’s WACC + Division’s WACC

= 0.037 + 0.01030

= 0.047

= 47.3% * 1.2

= 5.676 %

Since home products beta is above 1, we assume it is a high risk project. It will be

evaluate using 1.2 times divisional rate.

Division: Real Estate

Re = Rf + βε * (Rm – Rf)

= 0.08 + 0.6 (0.135 – 0.08)

= 0.08 + 0.6 (0.055)

= 0.08 + 0.033

= 11.30 %

Hurdle rates per division = cost of debt’s WACC + Division’s WACC

= 0.037 + 0.00622

= 0.04322

= 0.0432% * 0.9

= 3.888 %

Since home products beta is below 1, we assume it is a low risk project. It will be

evaluate using 0.9 times divisional rate.

5. Do you agree to use the company’s target capital structure of 45 percent debt

and 55 percent equity as each division’s capital structure as recommended by

Linda? Explain your answer.

Debt financing decisions mainly depend on the following two items:

1. Return on investment

2. Cost of debt.
 Yes, I agree with the target capital recommendation by Linda. As long as the return

on

Equity is higher than cost of debt it should be proceed. If the return on investment is

higher than cost of debt, cost of debt should be accepted. Subject to a condition that

after tax cost of debt does not exceeded cost of equity. In decisions related to source

of finance, source having least after tax cost should be selected in such a way that

WACC is least.

6. Suppose Ceramic Coatings Division has an exceptionally large number of

projects whose returns exceed the risk-adjusted hurdle rates, so its growth

substantially exceeds the company average. What effect would this have, over

time, on Rainman’s corporate beta and on the overall cost of capital?

The effect of the growth exceeds the company average:

 Stock price will rise and investor numbers will increase. The rise in stock price would

influence beta, the role of beta is to know the sensitivity of changes in the share price

of the company relative to the market price.

 Then it will attack the attention on lender to give more credit loan. The growing

number of lending in the company, it will affect the increase of debt equity ratio. It

means that Rainman has higher risk of debt repayment.

In conclusion, the impact of the growth exceeds the average business, Rainman's beta

and capital cost will rise, this is due to the increased stock prices of Rainman and

credit loans. This seems like a positive indicator for Rainman, but the higher the loan

exposure, the more dangerous it is for the company.

 7. One problem with a market risk analysis relates to differences in reported

beta coefficients. Explain why reported historical beta values are so

inconsistent. Do historical betas provide good measures of the future

riskiness of firms?

The beta is one of the most important but elusive parameters in finance. According to the

CAPM, it is a measure of the so-called systematic risk. Pablo (2002) states that there are

differentiate the historical beta from the expected beta, the historical beta being get from

the regression of historical data, and the expected beta being the relevant one for

estimating the cost of equity (the required return on equity). Historical betas are used for

several purposes:

To calculate the cost of equity of companies.

To rank assets and portfolios with respect to systematic risk.

To test CAPM and mean-variance efficient.

One problem with a market risk analysis such as the one Mr Rayyan is conducting

relates to differences in reported market beta coefficients. Some services calculate and

reported straight historical betas, while others make adjustment for the tendency of betas

to approach 1.0 overtime. A few services even attempt to include fundamental economic

factors in their beta calculations. There are three ways people can choose to evaluate beta

value. Their decisions make reported beta values, even pure historical betas are so

inconsistent in different reports.

The first tool Rayyan use concerns the length of the estimation period. Rayyan uses

estimates of betas like Standard and Poor’s 500 and this number use five years of data.

The trade-off is simple: A longer estimation period provides more data, but the firm itself
might have changed in its risk characteristics over the time period. Rayyan use the index

of Standard & Poor‘s 500 index which mean this number uses the data in 5 recent years

and they come up with a different number in compare to pure historical beta. This also

explains why even pure historical beta is different.

Historical beta is based on a regression of past returns against the market. Historical

beta does not take into account recent changes in volatility or capital structure so this will

not be as useful as the predicted beta. Blume (1975) finds that betas estimated using past

data alone, historical betas, are poor predictors of future stock returns. He showed that

betas migrate toward 1.0. Such work led to the replacement of historical beta with

adjusted betas to better predict future risk. From this, we have a conclusion that historical

betas do not provide good measure of the future riskiness of firm or divisions.

The second estimation issue relates to the return interval. Returns on stocks are

available on an annual, monthly, weekly, daily and even on an intra-day basis. In this

case Rayyan examined the betas for publicly held real estate, abrasives, general

manufacturing on an annual, monthly, weekly etc. on an intra-day basis. Using daily or

intra-day returns will increase the number of observations in the regression, but it

exposes the estimation process to a significant bias in beta estimates related to non-

trading. For instance, the betas estimated for small firms, which are more likely to suffer

from non-trading, are biased downwards when daily returns are used. Using weekly or

monthly returns can reduce the non-trading bias significantly.

The third estimation issue relates to the choice of a market index to be used in the

regression. The standard practice used by most beta estimation services is to estimate the

betas of a company relative to the index of the market in which its stock trades. U.S.

stocks relative to the NYSE composite or the S & P 500. While this practice may yield
an estimate that is a reasonable measure of risk for the domestic investor, it may not be

the best approach for an international or cross-border investor, who would be better

served with a beta estimated relative to an international index.

To the extent that different services use different estimation periods, different market

indices and the different return interval will give the different result of the beta.

Academics also recognize some possible problems with different financial data sources.

Kahle and Walking (1996) show that data selection and use can still have great impact.

Roger and Ross (2003) determine whether differences in beta estimates impact portfolio

selection and subsequent return performance is a natural extension of line of work.

To solve the problems of using historical betas, there are another method of determine

the betas of company. Rosenberg and Guy (1976) present that a method to adjust

historical betas for risk variables such as leverage. Investment practitioners label these

estimates as fundamental betas. Rosenberg and Guy (1976) estimate beta with past data

and adjust that estimate according to set of individual corporate financials. This suggests

that beta may change with corporate characteristics over time.

 Reference

1. Blume, Marshall E. (1975) Betas and Their Regression Tendencies. Journal of

Finance, 30 (3), 785-795.
2. Rosenberg, Barr & Guy, J. (1976). Beta and Investment Fundamentals, Part 1.
Financial Analyst Journal, 32, (3), 60-72.
3. Rosenberg, Barr & Guy, J. (1976). Beta and Investment Fundamentals, Part 2.
Financial Analyst Journal, 32, (4), 62-70.
4. Kahle, Kathleen M. & Walkling, Ralph A. (1996) The Impact of Industry
Classifications on Financial Research. Journal of Financial and Quantitative
Analysis, 31 (3), 309-335.
5. Ross, Roger (2003) The Beta Mystery—Are Investors Misled. Association for
Financial Counseling and Planning Education, 57.