Corporations often use different costs of capital for different operating divisi
ID: 2654282 • 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’s cost of capital? Your initial response should be 200 to 250 words.
Explanation / Answer
Weighted average cost of capital calculates the cost of capital by using the cost of debt (after tax) and cost of equity and multiplying it with their respective weights in the total capital.
WACC = weight of debt*after tax cost of debt+weight of equity*cost of equity.
Suppose a firm has 50% debt and 50% equity in its capital. Its after tax cost of debt is 8% and cost of equity is 14%.
WACC = 0.50*8%+0.50*14% = 4%+7% = 11%.
WACC is used as a hurdle rate. It is used to discount future cash flows. In case of a diversified company like Samsung, it would be wrong to use a single company wide WACC. It is because Samsung operates in different segments like smartphones, TVs, fridge, etc. Each segment or division has its own risk profile. The smartphone segment is highly risky and demand is dependendt on new launches. This is not the case with the fridge or AC division and they are less risky. Thus each department or division should use its own cost of capital, reflecting its intrinsic risk.
If a single wide WACC is used, then the riskier projects will benefit. This is because, the more the risk, the more return is required. So in case of riskier projects the hurdle rate will be much higher than conservative projects. This will cause the cash flows of riskier projects to be discounted at a higher rate. By using a company wide single rate, the riskier projects will get the benefit of being discounted at a lower rate, thus getting more resources.
The reverse is true in case of conservative projects.
For developing the cost of capital of each division, the initial project outlay should be calculated. How this investment outlay was funded should be considered to calculate the WACC of the division. Suppose Samsung issued 9% bonds to raise $100,000,000. This amount was used for the smartphone division only. So this amount should be used while calculating the debt portion of smart phone division, and should not be alloted to any other division. This way the division wise cost of capital can be calculated.