Corporations often use different costs of capital for different operating divisi
ID: 2700709 • 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%u2019s cost of capital?
Explanation / Answer
As the previous section on WACC explained, the 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. What happens when a company wants to finance a project with a risk level that is lower or higher than that of the overall firm? Divisional and project costs of capital allow a firm to use a different cost of capital for company divisions and projects that have different levels of risk.
First, 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.
While this method isn't foolproof, it should result in superior decision-making compared to ignoring differential risk and using WACC for everything. Ignoring differential risk would result in accepting or rejecting projects based on an invalid premise.
What would be an example of a project or division that has a higher risk than the firm's risk? 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.
When conducting capital budgeting for foreign projects, it is important to take into account thenational inflation rate of the foreign country. This is important because the inflation rate of the country might affect the interest rates, cost of the project and any potential cash inflows/outflows.Foreign exchange rates also make capital budgeting for foreign projects complex. When the cost of a project is calculated, it is usually done in the currency of the parent company, which is located in the "home" or domestic country. The numbers are then converted to the currency of the foreign country. Since exchange rates fluctuate and are usually not the same at any given time, calculating the cost and benefits of a project can be very complex. (For more on foreign investing