Group 9RISHABH RAJ 13PGP104ROHIT ANAND GARG 13PGP105RUCHITA RAJU BURDE 13PGP106SILPA BEHERA 13PGP107SMRUTI PRAKASH 13PGP109

Strategic Hurdle Rates for Capital Investment

Concept of a single screen – Comparison of expected ROI with the company’s cost of capital

Flaws in the concept

1. Single Hurdle Rate

2. Hurdle rate as cost of capital

3. Investment strategy is a bottom up process

TRADITIONAL APPROACH

PROBLEMS ENCOUNTERED

Corporate Opportunity Cost

• In Question?• The relevance of cost of capital to determination of the

investment hurdle rate.

• Two conclusions are important here:• Corporate opportunity cost should replace the stockholder opportunity cost

for determining the primary hurdle rate.

• Differentiation to be made between Strategic and Tactical investment decisions.

• Redeployment of Strategic investment fund involves considerable time and uncontrolled circumstances.

Two Levels of ChoiceStrategic Decision Tactical Decision

Policy level decisions that come out of long range planning

Smaller per individual proposal that continue the business on an existing course.

Concerned with deliberate changes over a long period allowing for major transformations.

Concerned with near future with weightage to past decisions and present scenario.

Hurdle Rate Grid• In reality, the organization is divided into various

segments which work independent of each other, generate their own income and have their own set of managers.

• Hurdle rate should be analysed for different segments of the economy.

• The strategy deals with the aggregate allocation of capital to the major segments of the business and defines the proportions and rate of growth of each relative to the others.

Analysing Divisional Hurdle Rate of ABC Company

Division Name Current ROI Contribution to Earnings

A 8% 50%

B 6% 10%

C 10% 25%

D 12% 10%

E 14% 5%

Total  9% 100%

Hurdle Rate = 11%

Tactical Decisions for ABC Company• Few of B divisions proposals are likely to clear the

hurdle and those that clear have little managerial rationale

• To sustain B, some minimum capital commitment is required to maintain current market potential until decisions are made to liquidate the division.

• Hurdle rate needs to be reviewed for the division B because of several reasons like market conditions or high competition etc.

Strategic Decisions for ABC Company• Management can decide whether to maintain, sell or liquidate

the division

• Decisions are made not on the division’s capability but on the expected rate of return on other strategic investment alternatives.

• Any decision are made considering the returns of other divisions.

• Internal Corporate Opportunity Cost – Decisions are made considering the returns of other divisions.

• External Corporate Opportunity Cost - Decisions are made considering the returns of creating new divisions in the organization.

Stockholders’ Interest• Where would we consider stockholders’

options?• Weak management of a weak company• Rationalize investments that reflects the marginal

internal and external options.

• Problem lies in:• Either in the set of investment alternatives selected,

related industry and competitive environment • Caliber of its management

Stockholders’ Interest (contd.)

• Possible Solution• Management change• Altering Strategy

• Implications• Setting of over optimistic forecasts.• Investment in high risk ventures.

Stockholders’ Interest (contd.)

• When can it benefit?• The top management use it performance standard

for review.• Only in context of Long range planning.

• Budget allocation based on strategic hurdle rates ,which can be on the basis of:

• Internal: Returns of the best performing division.• External: Best of many alternatives outside business.

• Budget Allocation based on Tactical Hurdle rates should be on the basis of:

• Internal: Overall demonstrated return of division based on realistic assessment of targets and past performance.

• External measure compares with most efficient competitor.

Conclusion