Question

(Divisional costs of capital and investment decisions​) Saddle River Operating Company​ (SROC) is a​ Dallas-based independent oil and gas firm. In the​ past, the​ firm's managers have used a single​ firm-wide cost of capital of 13 percent to evaluate new investments.​ However, the firm has long recognized that its exploration and production division is significantly more risky than the pipeline and transportation division. In​ fact, firms comparable to​ SROC's E&P division have equity betas of about 1.4​, whereas distribution companies typically have equity betas of only 0.9. Given the importance of getting the cost of capital estimate as close to correct as​ possible, the​ firm's chief financial officer has asked you to prepare cost of capital estimates for each of the two divisions. The requisite information needed to accomplish your task is presented​ here: • The cost of debt financing is 8 percent before taxes of 34 percent.​ However, if the​ E&P division were to borrow based on its projects​ alone, the cost of debt would probably be 9.8 ​percent, and the pipeline division could borrow at 5.3 percent. You may assume these costs of debt are after any flotation costs the firm might incur. • The​ risk-free rate of interest on​ long-term U.S. Treasury bonds is currently 3.4 ​percent, and the​ market-risk premium has averaged 5.5 percent over the past several years. • The​ E&P division adheres to a target debt ratio of 20 ​percent, whereas the pipeline division utilizes 30 percent borrowed funds. • The firm has sufficient internally generated funds such that no new stock will have to be sold to raise equity financing.

a. Estimate the divisional costs of capital for the​ E&P and pipeline divisions. b. What are the implications of using a​ company-wide cost of capital to evaluate new investment proposals in light of the differences in the costs of capital you estimated​ previously?

Answer 1

Cost of Capital for E&P Division

Before tax cost of Debt=9.8%

After tax cost of debt =9.8*(1-0.34)=6.47%

Rs=Rf+Beta*(Rm-Rf)

Rs=Cost of Equity

Rf=Risk Free Rate=3.4%

Rm=Market Return

Rm-Rf=Market Risk Premium=5.5%

Equity Beta=1.4

Rs=3.4+1.4*5.5=11.10%

Cost of Equity =11.10%

Debt Ratio=20%=0.2

Total Liabilities=D

Total Equities=E

Total Assets=D+E

Debt Ratio=Total Liabilities(D)/(Total Assets)=D/(D+E)=0.2

Weight of Debt in the capital structure=0.2

Weight of Equities=1-0.2=0.8

Cost of Capital for E&P Division=Weight of Debt*Cost of Debt+Weight of Equity*Cost of Equity=0.2*6.47+0.8*11.1=10.17%

Cost of Capital for PIPELINE  Division

Before tax cost of Debt=5.3

After tax cost of debt =5.3*(1-0.34)=3.5%

Rs=Rf+Beta*(Rm-Rf)

Rs=Cost of Equity

Rf=Risk Free Rate=3.4%

Rm=Market Return

Rm-Rf=Market Risk Premium=5.5%

Equity Beta=0.9

Rs=3.4+0.9*5.5=8.35%

Cost of Equity =8.35%

Debt Ratio=30%=0.3

Weight of Debt in the capital structure=0.3

Weight of Equities=1-0.3=0.7

Cost of Capital for Pipeline  Division=Weight of Debt*Cost of Debt+Weight of Equity*Cost of Equity=0.3*3.5+0.7*8.35=6.90%

b. Projects should be evaluated based on risk adjusted cost of capital instead of plantwide cost of capital.

If Plant wide cost of capital is higher than the actual cost of capital of a project, a project which should be accepted will get rejected, resulting in loss of opportunity.If Plantwide cost of capital is lower than the actual cost of a project, a project which should not be accepted is likely to be implemented resulting in a loss