Divisional Costs of Capital - Financial Management

The approaches already discussed provide an estimate of the return required by equity investors on investment projects of “average” risk.When some divisions of a company have lower (higher) systematic risk than others, the discount rates for projects adopted by these divisions should be lower (higher) than the discount rate for the firm as a whole. For example, West Coast Power is an electric utility that has a calculated beta of 0.91.

The firm has three divisions: the electric power generation and distribution division, which has 70 percent of the firm’s assets; an oil and gas exploration division, which has 20 percent of the assets; and a transportation and barge division, which has 10 percent of the assets. Using surrogate market information —that is, estimating the beta for one or more firms that are purely (or nearly so) engaged in the business of each of West Coast’s major divisions (the so-called pure play approach) and using these surrogate betas (after adjusting for leverage differentials using Equations)—the beta for each division is estimated as shown here:

Note that the weighted average of the divisional betas is equal to the firm’s overall beta— in this case, 0.91. Conglomerate firms that compete in many different product and geographical markets, such as United Technologies or General Electric, often estimate separate divisional costs of capital. These divisional costs of capital reflect both the differential required returns of equity investors, estimated from the security market line, and the differential debt -carrying capacity of each division.

For example, the parent company may have a debt-to-total-assets ratio of 60 percent. Individual divisions within the firm may compete against other firms that typically have higher or lower debt -to-total-assets ratios. In computing each divisional cost of capital, many firms try to reflect both the differential divisional risks and the differential normal debt ratios for each division.

Formulas for Computing Component Costs

Formulas for Computing Component Costs

Formulas for Computing Component Costs

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Financial Management Topics