Divisional Hurdle Rates at Lanka Diversified PLC
Lanka Diversified PLC reports two divisions. The FMCG division (60% of capital employed) is mature and cash-generative; the agri-processing division is building an export-focused plant and is considered riskier. The group targets 40% debt at market values, currently pays 11% pre-tax on debt, and faces a 30% corporate tax rate. The risk-free rate is 9.5% and the equity risk premium is 6%. The group equity beta is 1.10. The treasury team applies a single group WACC of 12.5% to all projects. The agri division proposes a LKR 2.4bn project expected to generate LKR 690m of annual after-tax operating cash flow for five years, with no terminal value. The FMCG division's pure-play peer has an equity beta of 0.75 and 25% debt-to-equity; the agri peer has an equity beta of 1.45 and 60% debt-to-equity. The board asks whether the project should proceed and whether the group hurdle rate is appropriate.
1. Compute the group WACC and separate divisional WACCs using the CAPM and relevered betas. Explain why the single group rate is inappropriate.
Read the worked answer
After-tax cost of debt = 11% × (1 − 0.30) = 7.7%. At the group target, E/V = 60% and D/V = 40%.
Group: Ke = 9.5% + 1.10 × 6% = 16.1%; WACC = 0.60 × 16.1% + 0.40 × 7.7% = 12.74%.
FMCG: unlever the peer beta: βu = 0.75 / [1 + 0.70 × 0.25] = 0.638. Relever at group gearing: βL = 0.638 × [1 + 0.70 × (40/60)] = 0.936. Ke = 9.5% + 0.936 × 6% = 15.12%; WACC = 0.60 × 15.12% + 0.40 × 7.7% = 12.15%.
Agri: βu = 1.45 / [1 + 0.70 × 0.60] = 1.021. Relever: βL = 1.021 × 1.4667 = 1.498. Ke = 9.5% + 1.498 × 6% = 18.49%; WACC = 0.60 × 18.49% + 0.40 × 7.7% = 14.17%.
The group rate of 12.5% is close to the group WACC but is not a divisional hurdle rate. Using it would overstate the FMCG hurdle by about 35 basis points and understate the agri hurdle by about 167 basis points. That systematically pushes capital toward the riskier division and away from the safer one.
2. Evaluate the agri project at the group rate and at the divisional rate. Recommend a decision and note the limitations of your analysis.
Read the worked answer
At 12.5%: annuity factor for five years = (1 − 1.125^−5) / 0.125 = 3.561. NPV = −2,400 + 690 × 3.561 = +LKR 57m.
At 14.17%: annuity factor = (1 − 1.1417^−5) / 0.1417 ≈ 3.419. NPV = −2,400 + 690 × 3.419 = −LKR 41m. The IRR is approximately 13.9%, between the two rates.
On the correct divisional rate the project destroys value and should be rejected unless there are unquantified strategic benefits, such as export market access or a valuable option to expand. Accepting it at 12.5% would cross-subsidise a risky division with FMCG cash flows and raise group risk without compensation.
Limitations: pure-play betas are estimates; a zero debt beta is assumed; the target gearing may not hold; the peers may differ in country and regulatory risk; and the cash-flow risk may warrant a project-specific premium. Recommendation: reject on financial grounds, or set a 14.2% hurdle and ask management to renegotiate capex or secure a higher offtake price.