PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

294 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESwill be provided by management based on its appraisal of the acquisition’srelative risk and required return. When not providedby management, the hurdle rate can be estimated using a varietyof security valuation methods. 22 In either case, when establishingthe hurdle rate, it is important for the analyst to consider severalissues, including the following:1. Risks attributable to business activities of the acquisitionThe risk attributable to the business activities of the acquisitiondetermines the cost of the capital required to make theacquisition. This risk measure should not be confused with therisk associated with the acquiring entity, which may be different.The risk of a firm, in total, reflects an interaction of the risksof its underlying business activities. The cost of capital of anyparticular activity may differ from that of the firm as a whole.2. Consideration of multiple hurdle ratesIf the target acquisition is engaged in several activities (e.g.,different lines of business) of varying risk, it may be appropriateto consider projecting several streams of free cash flow and discountingthem at different rates. An alternative to this approachmaybetoallocatecapitaltobusinessactivityinsuchawayastoequalize risk across lines. If this approach is used, then a singlediscount rate for all cash flows may be appropriate.One reason to consider the latter approach is that one cangenerally observe the hurdle rate only for the firm as a whole,and not for its component parts. Thus, the hurdle rates reflectthe average risk of the firm’s activities and are not necessarilyappropriate for any single business. If there were large samples ofpublicly traded firms specializing in particular lines of business,then it would be possible in theory to observe the hurdle rate forthose specific activities. In practice, however, there are a limited22 The most prominent models in widespread use are the capital asset pricing model(CAPM) and the dividend valuation model (sometimes known as the DCF or Gordongrowth model). Both models are described in numerous sources, including Damadaran[7].