Assignment 1: Cost Of Capital Corporations Often Use Differe

Assignment 1cost Of Capitalcorporations Often Use Different Costs Of C

Assignment 1: Cost of Capital. Corporations often use different costs of capital for different operating divisions. Using an example, calculate the weighted cost of capital (WACC). What are some potential issues in using varying techniques for cost of capital for different divisions? If the overall company weighted average cost of capital (WACC) were used as the hurdle rate for all divisions, would more conservative or riskier divisions get a greater share of capital? Explain your reasoning. What are two techniques that you could use to develop a rough estimate for each division’s cost of capital? Your initial response should be 200 to 250 words.

Paper For Above instruction

The practice of companies applying different costs of capital to various divisions reflects the need to accurately assess the risk-adjusted return on investments within diverse operational areas. The weighted average cost of capital (WACC) is a critical metric used to determine the necessary return on invested capital, factoring in the cost of equity and debt. To illustrate, consider a company with a division involved in high-tech innovation and another in mature manufacturing. Suppose the high-tech division has a higher cost of equity due to increased risk, say 12%, while the manufacturing division's cost of equity is lower, around 8%. If both divisions finance their projects proportionally, and the company's debt cost is 5%, with a debt-to-equity ratio of 0.5, the overall WACC can be calculated as follows:

WACC = (E/V) Re + (D/V) Rd * (1 - Tc)

Where:

- E = market value of equity

- D = market value of debt

- V = E + D

- Re = cost of equity

- Rd = cost of debt

- Tc = corporate tax rate (assumed 21%)

Plugging in the values:

E/V = 0.667, D/V = 0.333, Re varies per division, but suppose overall Re is an average of the two divisions weighted by their risk profiles. The resulting WACC may be around 7.5% to 9%.

Potential issues arise when different techniques are used to determine the cost of capital. Such issues include inconsistency in risk assessments, difficulty comparing divisions on a uniform basis, and possible bias if divisions pursue riskier projects to inflate their WACC estimates.

Using the overall company WACC as a hurdle rate generally favors more conservative divisions because they have lower actual risk and thus could be excluded from higher-return projects that are feasible at higher division-specific costs. Conversely, riskier divisions may appear to underperform if their projects are undervalued using the company's average WACC.

Two methods for estimating each division’s cost of capital include:

1. Adjusting the firm’s betas for each division based on industry risk factors.

2. Using comparable companies’ cost of capital metrics specific to each division’s industry.

Accurate division-specific cost of capital assessments are vital because they align project evaluation with the actual risk profile, promoting optimal capital allocation and avoiding over- or under-investment in certain segments.

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