Sound capital appropriation is an important aspect in all organizations especially for those with several primary operating divisions. Capital is an essential component that determines the success of failure in an organization in terms of growth and profitability. Therefore, a proper method of cost of capital analysis is necessary for establishing capital expenditures in all the operating divisions. An appropriate method ensures that accurate information regarding capital use which is vital in strategic decisions necessary for maintaining a sustainable growth in an organization. Therefore, an appropriate method for use in ExxonMobil will be identified in order to ensure optimal use of capital in the firm.
ExxonMobil has several divisions that should be considered in determining the firms average cost of capital. As a financial analyst, I would not recommend that ExxonMobil use a company-wide cost of capital for analyzing capital expenditures in all the business units. The use of a company-wide cost of capital leads to challenges in the process of making key company decisions involving investment in projects. Such decisions are vital and critical for the success of a company. The company-wide cost of capital is always determined from the average risk of the whole firm. Therefore, use of a company-wide cost of capital by a multidivisional company like ExxonMobil will increase the chances for the high level management to make wrong decisions based on invalid premises. The rate used maybe too high for low risk divisions and too low for high risk divisions. Therefore, this will mean that the firm will accept bad high risk projects and reject good low risk projects. As such, the company will significantly lose on many opportunities necessary for facilitating growth and profitability of the company. Use of individual divisions’ cost of capital is essential for effectiveness and efficiency in determining expenditure in the different business units (Keown & Martin). Divisional costs of capital effectively reflect the risk of each division therefore making a reliable basis of laying company decisions. Estimating divisional costs of capital is important because the process involves various factors such as political rivalries within the firm hence the need to use a cost of capital that is as comprehensive as possible.
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I would evaluate the cost of capital for the divisions by estimating the cost of equity capital for ExxonMobil from its beta by using the security market line. This is because the divisions basically lack separate stocks hence beta cannot be calculated for them directly. I would then identify a stand-alone company com comparable to a particular division in order to effectively determine the beta for each division. I would then adjust the betas of the stand-alone companies to remove the effects of financial leverage in order to eliminate the variance caused by variations in financial leverage. I would finally calculate the unlevered beta for each division in ExxonMobil which I will use to estimate the pure equity cost of capital.
I will consider several weights that will be used for the various sources of capital. The several weights include book value weights, market value weights and marginal weights. The book value weights are used for actual or historical weights. The book value weights facilitate determination of the relative proportion of various sources of capital (Pablo, 2010). They are important in determining the capital structure in terms of debt-equity ratio. The book value weights are important because they are operational in nature because they are easily obtained from the published annual reports of the firm. As such, firms usually set their capital structure targets using book values rather than the market value. Moreover, the book value weights are effective in determining the influence of retained earnings on a firm’s capital structure. The market value weights are used to determine the current weights of the various sources of capital. They will be used to closely approximate the actual amounts to be received from the proceeds of securities. As such, the cost of each particular source of capital that constitutes the overall capital structure of a firm is normally calculated based on the prevailing market value. However, there are several practical difficulties associated with market value weights. This is because the market value of securities normally fluctuates and they are also not readily available like book value records which are the published reports of the firm. Moreover, the analysis of capital structure in terms of debt-equity ratio is normally based on book value weights rather than the market value weights. The marginal weights are essential in analyzing the cost of capital regarding proposed future financing of a firm. The marginal weights are assigned to the specific costs depending on the proportion of each type of fund to the total amount of capital raised (Arnold & Crack, 2014). Therefore, the marginal weights correspond to the proportions of capital inputs the firm intends to employ in financing a proposed investment proposal. However, it is important to realize that marginal weight system does not consider the long term implications on the current capital structure of a firm.
Several factors should be considered while estimating the cost of individual sources of capital for each division of ExxonMobil. Several economic and political factors affect the cost of sources of capital available to various divisions of the firm. Different inflation rates, foreign exchange rates and political stability in the various countries where the divisions are located should be considered in the estimation of the cost of individual sources of capital for the particular divisions of ExxonMobil.
In conclusion, divisional cost of capital is recommended for ExxonMobil Company. This is because divisional cost of capital facilitates better decision making which is based on valid premises. It will lead to proper appropriation of the firm’s capital resources.
References
Arnold, T., Crack, T., Using the WACC to Value Real Options, Financial Analysts Journal , (2004), 60(6); 34-45
Keown, A., Martin, J., & amp; Petty, J. (n.d.). Foundations of Finance (8th ed.). Retrieved from https://online.vitalsource.com/#/books/9781269717694/cfi/4
Pablo, F., WACC: Definitions and Misconceptions, and Errors, Business Valuation Review , (2010), 29(4); 138-144
