In: Finance
Exxon Mobil ( XOM) is one of the half- dozen major oil companies in the world. The firm has four primary operating divisions ( upstream, downstream, chemical, and global services) as well as a number of operating companies that it has acquired over the years. A recent major acquisition was XTO Energy, which was acquired in 2009 for $ 41 billion. The XTO acquisition gave Exxon Mobil a significant presence in the development of domestic unconventional natural gas resources, including the development of shale gas formations, which was booming at the time. Assume that you have just been hired to be an analyst working for ExxonMobil’s chief financial officer. Your first assignment was to look into the proper cost of capital for use in making corporate investments across the company’s many business units.
a. Would you recommend that Exxon Mobil use a single company- wide cost of capital for analyzing capital expenditures in all its business units? Why or why not?
b. If you were to evaluate divisional costs of capital, how would you go about estimating these costs of capital for Exxon Mobil? 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.
Need some detailed answer without plagiarism.
a]
No, a single company- wide cost of capital is not recommended. This is because the risk of each business unit may be different. The source of capital used for each business unit may be different. A business unit which is newly setup will have higher risk than the company as a whole. Exxon is a huge company with many different business units, divisions etc., and each unit/division will have different risk profiles. Hence using a single company- wide cost of capital is not appropriate
b]
To estimate the divisional costs of capital, the single company- wide cost of capital can be adjusted upwards or downwards based on the risk profile of the specific division, and the sources of capital used for the specific division
For example, XTO Energy probably has higher risk due to its nature of business. Hence, the cost of capital should be adjusted by adding a risk premium to Exxon's overall cost of capital
If XTO was acquired using debt, the cost of capital would be lower than Exxon's average cost of capital. This is because the cost of debt is usually lower than cost of equity. The weight of debt would be increased, and the weight of equity would be decreased to recalculate the cost of capital.
If, on the other hand, XTO was acquired using only retained earnings, the cost of capital would be higher than Exxon's average cost of capital. This is because the cost of equity is usually higher than cost of debt. The weight of debt would be decreased, and the weight of equity would be increased to recalculate the cost of capital.