Mini Case 9 2: ExxonMobil Is One Of The Half Dozen

Mini Case 9 2 Chapter 9exxonmobil Xom Is One Of The Half Dozen M

Mini-Case 9-2 (Chapter 9) ExxonMobil (XOM) is one of the major global oil companies, operating through four primary divisions: upstream, downstream, chemical, and global services. The company has expanded over the years through acquisitions, notably the 2009 purchase of XTO Energy for $41 billion, which significantly increased its presence in the development of domestic unconventional natural gas resources, including shale gas formations. As a newly hired analyst reporting to ExxonMobil’s chief financial officer, the primary task is to determine the appropriate cost of capital for evaluating potential investments across the company's diverse business units.

Would you recommend that ExxonMobil use a single company-wide cost of capital for analyzing capital expenditures in all its business units? Why or why not?

Using a single corporate-wide cost of capital for all divisions is generally not advisable due to the heterogeneity of the risk profiles across different units. Each of ExxonMobil's significant divisions—upstream, downstream, chemical, and global services—operates within different environments with varying risk factors, capital structures, and market influences. For instance, the upstream division, involved in exploration and production, typically exhibits higher volatilities and greater exposure to commodity prices than the downstream refining segment, which is more stable but sensitive to regulatory and environmental factors. Chemical operations often have different cost structures and market dynamics, and global services' risks vary depending on geographic location and service type.

Applying a uniform cost of capital across non-homogeneous business units can lead to misvaluations — either overestimating or underestimating the true risk-adjusted return expectations for individual divisions. As a result, capital expenditures might be approved or rejected based on inaccurate assessments, adversely affecting the company's overall value creation strategy. It is therefore optimal to establish division-specific costs of capital that reflect each segment’s unique risk profile and capital structures, leading to more informed and balanced investment decision-making.

How would you go about estimating these costs of capital for ExxonMobil's divisions? Discuss your approach to evaluating the weights for various sources of capital and the estimation of costs for each source of capital.

Estimating divisional costs of capital involves a comprehensive process that considers the specific risk profile, capital structure, and market conditions pertinent to each business segment. The approach begins with calculating the division-specific beta coefficients, which measure each division’s systematic risk relative to the market. Since division betas are not directly observable, one common method is to decompose the overall corporate beta into segment betas, adjusting for each division's leverage and operational risk.

To determine appropriate weights for sources of capital—debt, equity, and possibly hybrid instruments—careful analysis of each division’s capital structure is necessary. These weights can be derived from division-specific financial data or estimated using a "bottom-up" approach, projecting future capital needs and funding mix based on investment plans. This method often involves using the target or projected leverage ratios based on industry standards or the company's strategic goals.

Regarding the costs of individual sources of capital:

- Cost of Equity: This is estimated using the Capital Asset Pricing Model (CAPM), adjusting the market risk premium for the specific risk profile of each division. The division-specific beta, along with the risk-free rate and equity risk premium, forms the basis for this calculation.

- Cost of Debt: This can be approximated by observing the current yields on comparable debt instruments in the market or by analyzing the company’s existing debt, adjusted for the division’s credit risk. Since divisions may have different credit risk profiles, the cost of debt must be tailored, potentially adjusted for tax advantages if interest expenses are tax-deductible.

- Hybrid Instruments: If applicable, the cost of preferred stock or other hybrid securities should be estimated based on current yields and dividend rates.

In sum, accurately estimating divisional costs of capital requires integrating market data, financial analysis, and strategic insights into each division’s specific risk factors. Additionally, the use of scenario analysis and sensitivity testing can help ensure robustness in these estimates, accounting for market volatilities and strategic uncertainties.

Conclusion

In conclusion, using a division-specific cost of capital provides a more precise and risk-adjusted basis for evaluating capital investment opportunities within ExxonMobil. It enhances the decision-making process by recognizing the unique risk profiles of each business segment, ultimately supporting better resource allocation and value maximization for the company. As the oil and energy sectors continue to face volatile market conditions, tailored financial metrics become even more critical for sustaining strategic competitiveness and long-term growth.

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