well-diversified investors

Zoller decided that a reasonable place to start her inquiry was to focus on the concept of market risk. After several discussions, she explained that well-diversified investors see the firm’s risk as the key determinant of its cost of equity capital and convinced NFP’s senior management that investors estimate risk, in large part although not exclusively, by a stock’s relative volatility as measured by its beta coefficient. Because NFP’s divisions have such different levels of risk, Zoller investigated publicly traded companies that were similar to each of the company divisions and examined their betas. She then analyzed the volatility of earnings in each division vis-a-vis earnings on the S&P 500 index and found a high level of correlation among divisions and with the index. With this information she separately met with each division director to determine the appropriate divisional betas. The agreed upon betas are listed in the following table:

DIVISION MARKET BASED PERCENT
OF CORPORATE ASSETS ESTIMATED DIVISIONAL BETA
Paper Products 38% 1.12
Timber Production 33% 0.98
Wood Products 15% 0.82
Plastic Products 9% 1.28
Real Estate 5% 1.43

Betty Zoller wanted to use these divisional betas to estimate the corporate beta and compare it against NFP’s corporate beta of 1.04 as reported by ValueLine and 1.12 as reported by Merrill Lynch. Before tackling a divisional risk-adjusted hurdle rate, she believed it was important to establish the company’s cost of equity by using the CAPM. For the purpose of comparison, she wanted to use the computed beta (as opposed to the ValueLine beta). She determined that the long-run treasury rate was 6.5 percent and the long-run return on the NYSE index was 14.2 percent. This exercise would clearly demonstrate that each division’s cost of equity differs from corporate cost, depending on the division’s risk.
Next, Betty needed to consider how capital structure should be incorporated into the weighted average cost of capital (WACC). Should the corporate average be used or should different divisions be assigned different capital structures and debt costs? If different capital structures are appropriate, how should they be derived? What interest rate should be used for debt? How should divisional equity costs be adjusted to reflect varying capital structures?
Management believes the company’s optimal capital structure is 42 percent debt. Betty initially decided to use this capital structure for each division. She also decided to use NFP’s before-tax cost of debt of 12.0 percent and its federal-plus-state marginal tax rate of 35 percent in all calculations. She reasoned that she was already going to have a hard time persuading management to accept multiple hurdle rates. Therefore, starting with a simple approach that was consistent with the beliefs of management would increase her chance of success. However, she realized that these decisions would be controversial and she knew that she must present strong arguments for her decision.
With her investigation clearly underway, Betty called the first meeting and presented her initial ideas. The meeting did not run smoothly. Kelly Dubree, vice president of the Real Estate Division, voiced a strong objection to the fact that a uniform capital structure of 42 percent debt was proposed. She argued that firms in the real estate industry averaged close to 75 percent debt and even the most conservative firms used about 60 percent debt. Based on the conservative firms’ bond
dol* ratings, the before-tax cost of debt for their competitors averaged only 11.25 percent, 75 basis
points below NFP’s overall cost of debt as a result of the riskiness of NFP’s other divisions.
Dubree argued that if she were forced to use a higher hurdle rate while competing firms use a lower rate, NFP would lose ground in the real estate business. John Sales backed her up, noting