Question

(Divisional costs of capital​) LPT Inc. is an integrated oil company headquartered in​ Dallas, Texas. The company has three operating​ divisions: oil exploration and production​ (commonly referred to as​ E&P), pipelines, and refining.​ Historically, LPT did not spend a great deal of time thinking about the opportunity costs of capital for each of its divisions and used a​ company-wide weighted average cost of capital of 14 percent for all new capital investment projects. Recent changes in its businesses have made it abundantly clear to​ LPT's management that this is not a reasonable approach. For​ example, investors demand a much higher expected rate of return for exploration and production ventures than for pipeline investments. Although​ LPT's management​ agrees, in principle at​ least, that different operating divisions should face an opportunity cost of capital that reflects their individual risk​ characteristics, they are not in agreement about whether a move toward divisional costs of capital is a good idea based on practical considerations.

a. Pete Jennings is the chief operating officer for the​ E&P division, and he is concerned that going to a system of divisional costs of capital may restrain his ability to undertake very promising exploration opportunities. He argues that the firm really should be concerned about finding those opportunities that offer the highest possible rate of return on invested capital. Pete contends that using the​ firm's scarce capital to take on the most promising projects would lead to the greatest increase in shareholder value. Do you agree with​ Pete? Why or why​ not?

b. The pipeline division​ manager, Donna​ Selma, has long argued that charging her division the​ company-wide cost of capital of 14 percent severely penalizes her opportunities to increase shareholder value. Do you agree with​ Donna? Explain.

Answer 1