Financial

Management : Assignment

The Need to Understand Divisional
Cost of Capital


Nikhilesh Naik (2019B2PGPMX013)
Nitesh Kumar (2019B2PGPMX014)
18th July 2021
Table of Contents
OVERVIEW ............................................................................................................................... 1
WACC : Our understanding ...................................................................................................... 1
Divisional Cost of Capital ........................................................................................................ 2
Why Divisional Cost of Capital Evolved? ................................................................................. 3
1. The Pure Play Approach .......................................................................................................................................... 4
2. The Subjective Approach ......................................................................................................................................... 4

Practical challenges faced in divisional cost of capital .......................................................... 6

OVERVIEW
In a push for further profitability, growth, diversification, incremental revenue or sometime
economies of scope, companies venture into various business units (referred here as divisions).
These divisions and their activities may or may not be related to each other hence cannot be
viewed with a single lens. (Example a production company may start consulting services divisions which
may have fundamentally different business model and financial metrics)

In a large company with multiple business units, Allocation of capital is the most significant part
of decision making. While most companies compare divisions on revenue, profitability, return on
assets, it has been observed that the same level of detailed comparison is not followed on Cost of
capital of various divisions.

WACC : Our understanding

It is the overall cost of capital of a company which is calculated as the weighted average of costs of
each component of capital where weights are market value of each capital. It incorporates all
sources of a company’s capital like common stock, preferred stock, bonds etc.

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Debt and equity are the two major components of company’s capital funding. Cost of capital is the
return that shareholders and debt holders will expect, WACC indicates return that both
shareholders and debt holders expect to receive. Company’s WACC is overall required return from
a company. WACC is used by managers to determine feasibility of opportunities mainly like
expansions or mergers. Also, it is used to gauge ROIC (Return on Invested Capital) performance.

Divisional Cost of Capital

Divisional Cost of Capital (or sometimes known as Project Weighted Average Cost of Capital) is the
hurdle/discount rate for assessing firm’s different divisions or projects having distinct risks
compared to overall company’s risks. It is a hurdle/discount rate determined after making
alterations to WACC w.r.t. change in risks of company as well as specific division/project of a firm.
Projects that equal or exceeds the hurdle rate are viewed as adding to shareholder’s wealth
maximization.

The company’s overall cost of capital is combination of different project/divisions cost of capitals.
The riskier division would have greater returns (disregarding the greater risk), so it would to be the
“front-runner.” The less fascinating operations might have good profit potential but that would end
up being overlooked. Large corporations are aware of this problem, and many work to develop
separate divisional costs of capital.

Two main questions in divisional cost-of-capital theory are:

(i) how to set the hurdle rates in an all-equity company

(ii) how those divisional rates should be adjusted for financial leverage, especially given that
financing decisions are often made at the company level. The most popular approach for
estimating divisional hurdle rates for all-equity firms is use of the capital asset pricing
model (CAPM). If one knew the "debt-capacity" contribution of each division, all-equity
hurdle rates for divisions could be adjusted according to division-specific debt-capacity
contributions.

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Why Divisional Cost of Capital Evolved?

Traditionally, companies have been using company’s overall WACC for all the projects irrespective
of their individual risk profile. To the extent that divisions in a corporation have degrees of risk and
financial characteristics that are different from the parent corporation, using overall corporate
hurdle rate is certain to lead to incorrect decisions and failure to maximize shareholders wealth.
The major consequences would be accepting high-risk projects which have IRR higher than WACC
and rejecting even the risk-free projects having IRR less than WACC. (For example, if Jubilant Food
who are into food services wishes to enter into new division of Pharmaceuticals, they can not apply WACC of
food services business to evaluate pharmaceuticals business as the risk profile for both business is different.)

The effect of failing to establish appropriate costs of capital for different projects or divisions is
shown in below image. It is taken from Pinches text, Essentials of Financial Management. As shown
in below figure, Project B has clearly higher IRR than Project A. If the deciding factor is the firmwide
cost of capital, it will be accepted, while Project A will be rejected. However, if the company
establishes divisional cost of capital based on risk, Project A (the lower risk project) can be seen as
exceeding divisional cost of capital, while Project B (the higher risk project) fails to cover divisional
cost of capital. This shows that by using divisional cost of capital and project risk considerations,
the decision is reversed and the firm is more likely to maximize shareholder’s wealth in risk averse,
efficient capital market environment.

Most important variables in determining divisional cost of capital are;

1. Risk
2. Strategic Importance of Division/Project
3. Division’s ability to raise its own capital

There are many approaches to while considering risk (which is key variable); company can estimate
beta for each division/project and then incorporate it in the capital asset pricing model for the

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division to determine the cost of common equity. This value can be combined with an assumed
cost of debt and the optimal capital structure for the division to determine the opportunity cost of
capital for the division.

Majorly used approaches to divisional cost of capital are:

1. The Pure Play Approach

In this approach, a listed company’s (operating in same space) WACC needs to be calculated
and evaluated. The company chosen should be very close to the proposed division/project.
a. Company should have clearly identifiable business lines
b. These business lines accounted for 100% of firm’s revenue i.e., there are no
miscellaneous revenue
c. There should not be unconsolidated subsidiaries
d. When geographical factors were deemed important, same operational geographical
area becomes important
e. When more than one company is identified, company with median beta would be
chosen
In the absence of such company, this approach is not a correct option.
For example, if pure-play approach is used to separately find the beta of division A, B and C
for multidivisional company and then weighted by division’s relative size to the entire
company, the weighted average beta closely approximated the actual beta for the
corporation.

2. The Subjective Approach

In this approach, categorization of division into low risk, moderate risk and high risk needs
to be done. Some adjustments need to be done in WACC percentages. These adjustments
are better than using overall company’s WACC. The effect of this crude partitioning is to
assume that all projects either fall into one of three risk classes or else are mandatory.

Methods by which risk is observed;

1. An objective measure such as beta of a public/listed company in same line of business as the
division.
2. An objective measure such as the average beta for the entire industry the division is in.
3. An objective measure, not marked related, such as the variability of the division’s earnings
compared to overall corporate earnings.
4. A subjective measure such as top management’s review of the perceived risk generally
associated with the division,

Objective factors;

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 1. Revenue
2. Total Assets
3. Net Profit and thereby margins
4. Fixed Asset to Total Asset
5. Return on Capital employed
6. Asset Turnover ratio
7. Debtor and working capital profile

Subjective factors;

1. Seasonal / Cyclical business consideration - Businesses such as Agriculture commodity

based are seasonal and high-risk profile
2. Unionization
3. Environmental Impact
4. Loss of asset value
5. Government involvement or interference in business
6. Change in technology – Sectors which are high technological interventions / digital
transformations are high risk – High reward sectors.
7. Brand Distinction – The brand name provides tremendous competition advance to certain
divisions.
8. Market Position – Where the company has dominant market share
9. Customer base dispersion – Where the company has large number of customers providing
diversity
10. Operational flexibility
11. Availability of resources
12. Added International risk - Foreign projects tend to carry risk and hence higher hurdle rate
is necessary to consider compared to domestic projects. They carry higher political risks,
foreign exchange risks, security risks, transfer payment risks etc.

Primary advantage of Divisional Cost of Capital is to make the process of selecting projects more
efficient and effective. It reduces the risk impact to a greater extent. Ideally, each project has to
accurately analyzed with determined costs and risks. Though cost and time to conduct such
research does not 100% guarantee perfect solution but it helps narrowing to decision.

An approach to estimating hurdle rates at the industry level is to be proposed and applied, that
specifically incorporates data from large, multi-division companies. In addition, by using weighted
costs of capital, this approach produces hurdle rates that require no further adjustment for
financing mix. This feature is especially attractive for applications in a setting of decentralized
investment decision making where corporate financing is still determined at a centralized level

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Practical challenges faced in divisional cost of capital

To understand the challenges in the divisional cost of capital, we also interacted with few CFO’s. Some of
the experiences (with related to Indian companies ) are
1. The degree of familiarity distorts the distinction between the divisions in the company Example –
the company may engage in various business models in a domain such as education - Preschool,
School, online learning is part of same industry but have fundamentally different business models
between the divisions. In such a scenario the company only prepares the financial bifurcation till
EBITDA level and not till the return on capital employed level.
2. Investor awareness – Most retail and institutional investors do not question the management on
the cost of capital between divisions. Hence doing the divisional exercise falls low in the priority
list of CFO’s.
3. The degree of gap between the cost of capital if low i.e., if the difference between 2 divisions cost of
capital is hardly 1/2 basis points – then the efforts to measure the same are high and such an
exercise is not considered worth the effort.
4. A number of organizations in India shares common resources between divisions such as corporate
level employees, Production, supply chain, marketing etc. leads to a distortion in the true
profitability of each division. Since the cost/ management accounting system in India is not very
evolved, a uniform cost of the capital across the company saves the headache and efforts.
5. Explaining “cost of capital” and its differences to different “Business leaders” (They lack expertise
on items below EBITDA ) is time consuming and difficult to justify.
6. Certain divisions are asset light and bank on the assets created by other divisions. Also, there might
be shared production facilities like plant and machinery. Cost of capital for various divisions can be
differentiated easily when companies are totally separate assets.
7. Identifying competition to determine cost of capital is a major challenge because of lack of
segregation in competition financials/ financial not available. Hence identifying the risk profile for
each division is difficult. This challenge is magnified in sectors where the competition is part of
unorganized sector.

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