Week 5 Case

Faisal Hassan Al Abdulmalik

American Public University
8 Jan, 2016

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?
Whenever a firm has more than two divisions, it must not use a company-wide cost of
capital for analyzing the capital expenditures in all its business units. The reason for this is
that each division poses different risk to the firm and each one of them has different
investment opportunities to be considered. Here the four divisions i.e. upstream,
downstream, chemical and global services all have risks of unique natures. Measuring them
all by a single discount rate does not seem to be an appropriate method. Using different
interest rates to evaluate effect of expected cash flows for differing time periods will result in
better decisions and sound analysis of the companys value. Single company-wide rate will
actually give a rate that might be too high for low risk divisions and too low for high risk
divisions thereby making the firm accept bad high risk projects and reject good-low risk
projects/investments. Therefore, using comprehensive divisional cut-off rates reflects the
appropriate riskiness of the division that will also be helpful in justifying the political
rivalries within the firm (Kruger, Landier, & Thesmar, 2011).

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.
In order to calculate the cost of capital for particular divisions, ExxonMobil will need
to calculate the cost of equity and cost of debt separately for each division and then calculate
their respective cost of capital. The cost of equity for the firm is calculated by estimating the
beta using the security market line. Since for each division there will not be any separate
stocks thereby making it impossible to calculate the betas directly so an indirect approach

will be used. The best method is to find stand-alone companies that are comparable to each of
the division. These betas are then adjusted for the financial leverage so that the variation in
these comparable companies due to variation in the financial leverage is eliminated. The next
step is to calculate the average unlevered beta for each division, which can further be used
in the security market line in order to calculate pure-cutoff rate. The unlevered beta
theoretically is re-levered at a rate that is used for each division. Once the beta is known by
using, the CAPM cost of equity for each division can be estimated (Collier, Grai, Haslit, &
McGowan, 2006).
Next step is to determine the cost of debt for each of the division will simply be the amount
of interest paid on the debt portion. By using these costs along with the relative risk free rate
and weights of the debt and equity, we will determine the weighted average cost of capital for
each division.
The relevant proportion of debt and equity in the capital used for the division will be
calculated by firstly calculating the percentage of debt and equity for ExxonMobil. Let us
suppose the weights are 40% debt and 60% equity. By determining, the capitals spend in each
of the divisions we will find the proportion by multiplying with the percentages
(Parasuraman, 2002).
Once all the data has been gathered, by using the formula for WACC the divisional cost of
capital will be calculated which would reflect the corresponding riskiness and size of the
division relatively.

References
Collier, H. W., Grai, T., Haslit, S., & McGowan, C. B. (2006). Computing the divisional cost
of capital using the pure play method. Wollongong: University of Wollongong.
Kruger, P., Landier, A., & Thesmar, D. (2011). The WACC Fallacy: The Real Effects of Using
a Unique Discount Rate. Mannheim: University of Mannheim.
Parasuraman, N. (2002, Nov). Ascertaining the divisional Beta for project evaluation -the
Pure Play Method- a discussion. Retrieved Jan 1, 2016, from Financial management:
http://business.baylor.edu/don_cunningham/pure%20play%20method.pdf