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CMA Final · Strategic Performance Management and Business Valuation · Corporate Risk Management Performance

Kaveri Pharma's risk-adjusted performance is measured by RAROC. A division earns net risk-adjusted income of Rs 18 crore after expected losses and costs, and the economic capital allocated to it is Rs 120 crore. The firm's hurdle rate (cost of equity) is 12%. Which statement is correct?

RAROC equals risk-adjusted income divided by economic capital, so 18 divided by 120 gives 15%. This is above the 12% hurdle rate, meaning the division earns more than the cost of the risk capital it uses and therefore creates value for shareholders.

  1. ARAROC is 15%, which exceeds the hurdle of 12%, so the division creates valueCorrect
  2. BRAROC is 15%, which exceeds the hurdle, but the division destroys value
  3. CRAROC is 6.67%, which is below the hurdle, so the division destroys value
  4. DRAROC is 12%, equal to the hurdle, so the division is value neutral

Explanation

RAROC = 18 / 120 = 15%. Since 15% is above the 12% hurdle, the division earns more than the required return on its risk capital and adds value (excess Rs 3.6 crore). Option C inverts the ratio by dividing capital by income wrongly.

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