Corporations often use different costs of capital for different operating divisi
ID: 2641935 • Letter: C
Question
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
Explanation / Answer
WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.
Here is the basic formula for weighted average cost of capital:
WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]
E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
Management must determine the project or division's risk as compared to the overall risk of the firm. A higher-risk project requires a discount rate that is higher than the WACC; a lower-risk project requires a discount rate that is lower than the WACC. For example, a company might use WACC minus 10% for very low risk projects, WACC minus 5% for low risk projects, WACC for projects with the same risk as the firm, WACC plus 5% for high risk projects and WACC plus 10% for very high risk projects.
Consider a company that wants to undertake a new project through one of its foreign subsidiaries. Capital budgeting for a foreign project is more complex than capital budgeting for a domestic project. Some of the reasons for the complexity are: a) Differing inflation rates, b) Foreign exchange rates and c) intangible factors like political climate.
Intangible factors, like the political and economic climate of the foreign country, add to the complexity of capital budgeting for foreign projects.
The cost of capital can be calculated by different methods these are discussed as below:
(I) Computation of cost by specific source of finance
1) Cost of debt: cost of debt means the interest payable on the debentures.
Kdb=I/P
If the debt is raised at discount or premium than the P (principal) will be changed to NP (Net proceeds).
Kdb=I/NP
And in case the firm has made payment of taxes than it will also be deducted.
Kdb=I/NP (1-t)
And if there are redeemable debentures than
Kdb= I+1/n(RV-NP)/1/2(RV-NP)
2.) Cost of preference share capital: a fixed rate of dividend is paid to the preference shareholders at regular intervals. If it is not paid to them than it affects the fund raising capacity of the firm.
Kp =D/P
If the preference shares has been issued at discount or premium than the P (principal) will be changed to NP (Net proceeds).
Kp=D/NP
3.) Cost of equity share capital: it is not legally binding upon the company to pay dividend to the equity shareholders. They are not paid dividend at fixed rate. Shareholders invest money with the hope that they will get the dividend and the firm must earn minimum rate of return to keep the market price of shares stable. The return may be in different form
d) Realized yield method: the earlier methods fail to estimate future dividend and earning correctly. To overcome this limitation actual average rate of return realized in the past is used. Average rate of return is found out with the help of dividend received in the past along with gain realized at the time of the sale of the shares.
4.) Cost of retained earning: it is the opportunity cost of dividend foregone by the shareholders.
Kr =D/NP + g
(II) Weighted average cost of capital: it is also called overall cost of capital or composite cost of capital as it is the composite cost of various source of capital. In this kind of cost of capital weights are given to specific cost of capital. The weights may have book value or market value. As market value represents the true value of the investors, so market value weights are preferred than the book value.
Kw =? XW/?W