Use of Single Company- Wide Cost of Capital for Analyzing Capital Expenditures
First of all, it must be understood that the overall riskiness of a firm is quite different than that of vulnerabilities associated with any specific division (business unit or segment) and project. Depending upon the overall risk of any organization and its capital structure formation, managers often use weighted average cost of capital (WACC) while the discount rate for any segment and project may be higher or lower .
Therefore, first thing which managers should do is evaluate the riskiness and cost of capital for any specific business unit or project. Afterwards, the company-wide cost of capital should be determined depending upon the security risk and sources of financing employed in the capital structure.
It is recommended that the managers of specific division, business unit or project should use a certain/related cost of capital. Later on, such a discount rate, cost of capital or hurdle rate of a project and business unit should be compared to a company-wide hurdle rate. This is so because if a company uses organization-wide cost of capital, this approach certainly considers all business units and projects as similar while ignoring the capital structure employed in certain areas.
This approach of employing business unit and project specific cost of capital is recommended because they assume different risks and market conditions. If only a single company-wide cost of capital, weighted average cost of capital (WACC), is used to evaluate a business unit and project, it will falsely assume that market conditions and uncertainties are same for all segments or projects .
The capital expenditures will also differ across business units and projects for which it is suggested to employ specific/related cost of capital for evaluation. However, when consolidated endeavors are undertaken, such as implementation of a new technology in all divisions, only in this case the managers can use single company-wide or weighted average cost of capital (WACC) for evaluation.
Divisional Cost of Capital and its Estimation
As stated earlier the previous section, the company must first compute the cost of capital specific to a certain business unit and project. This cost of capital or discount rate should be judged against weighted average cost of capital (WACC) of a company. However, since each business division or project has a certain risk and market conditions, it should employ its internal cost of capital instead of single company-wide discount rate.
In the same manner, the equity source of finance is divided into common and preferred equity holding. The cost is the required return on investment demanded by investors. They provide no tax benefit and the certain weights are assigned by the percentage employed in the total capital structure. When all the costs are computed for each division or project, they are added to one another to arrive at a business unit and project specific weighted average cost of capital (WACC).
References
Haider, A. (2014). Business Technologies in Contemporary Organizations: Adoption, Assimilation, and Institutionalization: Adoption, Assimilation, and Institutionalization. IGI Global.
Pandey, I. (2009). Financial Management. Vikas Publishing House Private Limited.
Whittington, O. R., & Delaney, P. R. (2011). Wiley CPA Exam Review 2012, Business Environment and Concepts. John Wiley & Sons.
