ExxonMobil ( XOM)
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?
No I will not recommend that ExxonMobil to use a single company wide cost of capital to analyze different capital expenditures in different business units. The basic reason of this fact is that different department possess different risk levels and different cost structures. The company wide cost of capital has to be adjusted for each business unit with the view to make more accurate business decisions. If the company wide cost of capital is used to analyze the projects, the company can drop some potential acceptable projects or can accept the projects that are not financially viable to the company.
It is important to note that capital projects require a lot of investment and future commitments and any improper decision can lead to long term financial losses for the company that can eventually impair the existence of the company. The main purpose of the capital projects is to add value to the company that can be viewed through the change in the stock prices over the period. So, the use of the proper cost of capital is an important aspect and can vary from companies to companies. But the most realistic approach is to use the more effective cost of capital that is based on the particular company’s risk level for each department.
Also, it is important to note the fact that the company wide cost of capital can be divided into different departments on the basis of the use of the capital resources i.e. debt and equity by each of the departments. Each department cost for debt and equity is determined and then adjusted with the risk factor for each department to determine the accurate and comparable cost of capital. Finally this cost of capital is used to evaluate different projects for these departments.
If you were to evaluate divisional costs of capital, how would you go about estimating these costs of capital for ExxonMobil? Discuss how you would approach the problem in terms of how you would evaluate the weights to use for various sources of capital as well as how you would estimate the costs of individual sources of capital for each division.
Estimating the cost of capital of each division is important to estimate the accurate weighted average cost of capital for each department. Cost of capital consists of the cost for each capital resource like cost of debt, cost of equity and cost of preferred stock. Determination of the after tax cost of debt is quite straight forward as all of the debt allocated to any particular department is used to determine the cost of debt. The average cost of the debts for any particular departments is determined and then are adjusted for tax impact to determine the after tax cost of debt. Cost of equity is based on the cost allocated to the common stock that can either be determined through dividend discount model or through (Capital Asset Pricing Model) CAPM. CAPM model is normally preferred to determine the cost of equity and the formula for CAPM model is as under:
Where Rf is the risk free rate that is normally used from the treasury bond yield
Rm is the rate of the market that is expected for any particular department on the basis of the market expectation and performance. Finally is the risk factor associated with the overall company. In this way the cost of equity is determined.
Cost of preferred stock determination is quite straight forward by determining the current yield of the preferred stocks and the formula is as under:
To determine the weights for the sources of the capital, the current market price is used to determine the total value of the capital. So, the total market value of debt plus total market value of the equity assigned to any particular department and total market value of preferred stock assigned to any particular department is summed to determine the total value of the capital assigned to particular department.
Now, weights of the particular cost elements are determined on the basis of the weighted assigned to each cost of capital elements. This cost of capital is used for evaluating any project for any particular departments with the view to determine more accurate project evaluation and acceptance criteria.