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Share whether you agree or disagree with my view of the use of the company's capital. Explain your reasoning.
Share whether you agree or disagree with my view of the use of the company’s capital. Explain your reasoning.
My example is of a company that finances with 40% debt, with 11% return and 20% preferred stock, with 8% return, and 40% common stock, with 14% return. The company’s tax rate is 40%.
40%(11%)(1-.4) + 20%(8%) + 40%(14%)
2.6% + 1.6% + 5.6% = 9.8%
What are some potential issues in using varying techniques for cost of capital for different divisions?
If a company uses different techniques to calculate the cost of capital for different divisions, this could cause an inconsistency between divisions. Also, this could cause problems if the company wants to merge two 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?
I think that the riskier divisions would need to use a different hurdle rate than the conservative divisions. More capital should be dedicated to the more conservative divisions because they are less risky and while the reward is not as great as the riskier divisions, it’s more of a sure investment.
What are two techniques that you could use to develop a rough estimate for each division’s cost of capital?
A second technique that can be used to estimate each division’s cost of capital is to use the worksheet for computing POL’s cost of capital. It results in the exact same number as the WACC calculation except it uses after-tax required returns rather than computing using the tax rate. There are three techniques that can be used to calculate the cost of common equity, or interest cost on common stocks. There is the CAPM approach to cost of common equity which states that “the required return on a risky investment equals the risk-free rate plus the product of the asset’s beta and the market risk premium” (Hickman, Byrd, & McPherson, 2013). Then there’s the discounted cash flow approach to cost of common equity which uses the same calculation as the required return of investors who purchase equity.
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