Analysis on Hurdle Rate

Cost of Capital at Ameritrade (Class Record, Rajat Kedia, 1501094)

BASIC PREMISE AND INTRO

The class started with the basic premise of the case. Prof Sethu discussed the following before starting the case by giving what is required in the case and some insights

• The objective of the case was to calculate Hurdle rate. Prof Sethu began by saying that the learning from this case is how to calculate β and the various pitfalls and challenges associated with it
• Prof Sethu then discusses about the target D/E ratio. He says that in real life, various projects are financed differently. It might not always be capital structure or Target D/E.
• Let’s understand the issue with an example. Suppose we have a project which is of 50 crores. Out of 50 crores 25 crores through Debt from debt market and 25 crores from Equity from equity Market. That is the ratio of capital structure and equity is both 1:1

• This situation is Problematic in real life. This is because Cost of rising from Equity market in a dull market is tough. Even if the investors subscribe I am selling it at the lowest price. So the company sells its equity asset at a lowest price. So in real life it is very difficult to always maintain the D/E ratio that is targeted says Prof SETHU.
• However PROF SETHU also says that although at no point we have the desired capital structure but over a period of time we keep it around to those levels.

LAST CLASS DOUBT ON D/E ratio

Prof Sethu then clears one of the doubts from the previous class which ALOK NANDA(1501065) had asked regarding which D/E to take in the last class. Prof Sethu argues by saying that when the person is buying equity he is thereby thinking of what will be its future. He sees D/E of the future and not of the present. He also knows that present value factors in present D/E and hence he invests taking a future D/E view in perspective. So the buyer cash flows will be in future and hence Prof SETHU believes that Future D/E is a better assumption.

DISCUSSION ON D/E RATIO AND ITS IMPLICATIONS

PALASH [1501088] asks how does company determine D/E of which PROF Sethu Replies he will discuss later with capital Structure.

However Prof SETHU tells that if we break the issue simply any investor or the equity holder has two types of risk

• Asset Risk
• Financing Risk

If asset risk increases we or the business takes less of financing risk and hence does not take much loan to maintain balance

If asset risk goes down then company is in the position to take more of loan capital.

So Prof SETHU explains it like for a high risk business low D/E and vice versa.