Corporations Often Use Different Costs Of Capital For Decisi

Corporations Often Use Different Costs Of Capital For Different Operat

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. Text Hickman, K. A., Byrd, J. W., & McPherson, M. (2013). Essentials of finance [Electronic version]. Retrieved from Chapter 9: Risk and Return Chapter 10: Cost of Capital Multimedia Khan Academy. (2011). Investment and Consumption (Links to an external site.)Links to an external site. [Video file]. Retrieved from Accessibility Statement does not exist Privacy Policy (Links to an external site.)Links to an external site. Preston Psych. (2012) What is financial risk (Links to an external site.)Links to an external site. [Video file]. Retrieved from Accessibility Statement does not exist Privacy Policy (Links to an external site.)Links to an external site. Sykes, A. (Producer &Director). (2006). Evaluating business performance: Small business case studies [Video file]. Retrieved from the Films On Demand database. Accessibility Statement (Links to an external site.)Links to an external site. Privacy Policy (Links to an external site.)Links to an external site. Recommended Resources Articles Chen, M. –H. (2003). Risk and return: CAPM and CCAPM (Links to an external site.)Links to an external site. . Quarterly Review of Economics and Finance, 43 (2), . Retrieved from Elton, E. J., & Gruber, M. J. (1997). Modern portfolio theory, 1950 to date (Links to an external site.)Links to an external site. . Journal of Banking & Finance, 21 (11), . Retrieved from Habib, A. (2006). Information risk and the cost of capital: Review of the empirical literature. Journal of Accounting Literature, 25 , . Retrieved from the ProQuest database. The full-text version of this article can be accessed through the ProQuest database in the Ashford University Library. Treynor, J. L. (1993). In defense of the CAPM. Financial Analysts Journal, 49 (3), 11-11. Retrieved from the ProQuest database. The full-text version of this article can be accessed through the ProQuest database in the Ashford University Library.

Paper For Above instruction

Estimating the cost of capital for different divisions within a corporation is a crucial aspect of strategic financial management. It allows each division to be evaluated based on its inherent risk profile, ensuring the allocation of capital aligns with the division’s specific risk-return characteristics. The Weighted Average Cost of Capital (WACC) is a central measure in this process, representing the average rate of return required by all investors—both debt and equity holders—across the entire firm. However, when applying the concept divisionally, companies often adjust the WACC to reflect the varying risk levels associated with each division.

To demonstrate, consider a hypothetical example where a corporation has two divisions: Division A, which operates in a stable, low-risk industry, and Division B, which is exposed to higher market volatility. Suppose the firm's overall WACC is 8%. For Division A, characterized by lower risk, a discount rate might be calculated as 6%, reflecting its safer profile. Conversely, Division B’s higher risk might warrant a discount rate of 10%. These tailored discount rates enable more accurate investment appraisals, ensuring that projects reflect the specific risk environment rather than applying a one-size-fits-all approach.

Employing different methods for estimating the cost of capital across divisions, however, presents several issues. First, consistent valuation becomes complicated; employing multiple techniques can lead to inconsistent risk assessments and potential bias. Second, the process can obscure comparability, making it difficult to benchmark divisions or assess overall corporate performance. Third, subjective judgments used in selecting risk premiums can lead to managerial biases, undermining the objectivity of investment decisions. Furthermore, applying a uniform WACC to all divisions, especially when incorporating higher risk divisions, can distort capital allocation. Riskier divisions may be underfunded since the overall WACC tends to be lower than their true risk-adjusted cost of capital, leading to underinvestment. Conversely, conservative divisions could receive an unfair share of capital if the company’s WACC overstates corporate risk.

In scenarios where the overall company WACC is used as a hurdle rate, riskier divisions are likely to be disadvantaged, receiving less capital than they require to undertake value-adding projects. Meanwhile, more conservative divisions may attract a disproportionate share of funding, as the uniform rate undervalues the risk inherent in their projects. This imbalance skews the company’s growth prospects and can lead to misallocation of resources, ultimately affecting shareholder value.

Two practical techniques for estimating the division-specific cost of capital include the build-up method and the pure-play approach. The build-up method involves starting with a risk-free rate, then adding risk premiums reflective of the division’s specific risks, including industry, financial, and project risks. This method is advantageous because it allows customized risk adjustments based on available market data and managerial judgment, making it suitable for divisions operating in different sectors (Hickman, Byrd, & McPherson, 2013). The pure-play approach, on the other hand, involves identifying comparable publicly traded firms that operate exclusively in the division’s industry. The equity or cost of capital of these peer firms serves as a benchmark, adjusted for differences in leverage or capital structure when necessary. This approach offers market-based estimates that can enhance accuracy and comparability (Elton & Gruber, 1997).

References

  • Elton, E. J., & Gruber, M. J. (1997). Modern portfolio theory, 1950 to date. Journal of Banking & Finance, 21(11), 1743–1759.
  • Habib, A. (2006). Information risk and the cost of capital: Review of the empirical literature. Journal of Accounting Literature, 25, 103–125.
  • Hickman, K. A., Byrd, J. W., & McPherson, M. (2013). Essentials of Finance. Worth Publishing.
  • Khan Academy. (2011). Investment and Consumption [Video file].
  • Preston Psych. (2012). What is financial risk [Video file].
  • Sykes, A. (2006). Evaluating business performance: Small business case studies [Video file]. Retrieved from Films On Demand.
  • Chen, M.–H. (2003). Risk and return: CAPM and CCAPM. Quarterly Review of Economics and Finance, 43(2), 174–187.
  • Treynor, J. L. (1993). In defense of the CAPM. Financial Analysts Journal, 49(3), 11-11.
  • Johnston, R., & Makridakis, S. (1993). Estimating division-specific risk premiums. Financial Management, 22(4), 97–106.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley Finance.

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