The Cost of Capital: How Much Does it Cost to Raise Money?

As a result of the recent acquisition of XTO Energy, Exxon Mobil is required to reevaluate the method of determining the accurate cost of capital for use in its investments. It would be economically incorrect for Exxon Mobil to use a single, company-wide cost of capital for measuring its capital expenditure in all of its divisions. This is because using this approach for estimating the cost of capital may lead either to overinvestment or to underinvestment into some divisions, seeing as the business units are uniquely different from each other (Correia, & Cramer 2008). As a result, there will be inefficiency with regards to the operations of all business units, as they all operate at different levels and using different processes. After having acquired XTO Energy, Exxon Mobil entered into another division under the domestic unconventional natural resources field. This means that XTO Energy projects have higher risks as compared to all other Exxon Mobil projects. Moreover, business sizes and processes are different with different environments and management practices. This means that the cost of capital for each business unit should be determined by the structure and processes involved in individual divisions. Each division has a different budget which influences decisions on the cost of capital, relative to the assets and operations required. Using a single company to estimate the cost of capital for all the business units in Exxon Mobil is inappropriate in determining the cost of capital as it is inaccurate when different levels of risks are involved in the business units. Although the method is easy to use, it is only relevant if all divisions have the same risks failure to which it lead to errors. 

The divisional cost of capital will be the best method for the evaluation of the cost of capital; it will enable Exxon Mobil to weigh the average cost of investments due to its recent acquisition. This is because, Exxon Mobil can only apply different costs of capital for its business units that have varying levels of risk. Since there are various sources of capital like loans and reserved capital, effective determination of the cost of capital for individual business units will increase their success. To evaluate the divisional cost of capital, Exxon Mobil should determine the risk of all its business units; this will include the financial and non-financial elements of these divisions (Bufka, Kemper, & Schiereck 2004). Since some divisions have higher risks than others, they will require a discount rate that is far higher than that of the weighted average cost of capital for divisions with lower risks. This will in turn enable the company to create a weighted average cost of capital to be used for every division. Secondly, Exxon Mobil will have to adjust the risk measure involved for debt effects. This magnifies the business risk of exposure, and is later used to estimate a cost of equity. The evaluation of weights of the cost of capital on the various business units will be based on expected value of each division. Other factors to be considered are inflation rates, opportunity cost, and uncertainties. This will involve analysis of all aspects of individual business units and use the data to estimate the cost of capital. This method makes sure that the company makes superior decisions instead of rejecting or undertaking projects based on invalid premises (Correia, & Cramer 2008). Furthermore, since there are different costs of capital for the business units under Exxon Mobil, it will be important to measure the market forces to establish a balance of both demand and supply. Analysis of individual capital input and output requirement for the business units will also play a significant role in estimating the cost of capital efficiently. Therefore, it is important to critically analyze all the factors involved in determining the cost of capital to avoid errors. 

References  

Bufka, J., Kemper, O., & Schiereck, D. (2004). A note on estimating the divisional cost of capital for diversified companies: an empirical evaluation of heuristic-based approaches. The European Journal of Finance, 10, ( 1), 68-80. 

Correia, C., & Cramer, P. (2008). An analysis of cost of capital, capital structure and capital budgeting practices: a survey of South African listed companies. Meditari: Research Journal of the School of Accounting Sciences, 16, ( 2), 31-52.