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Corporations often use different costs of capital for different operating divisions. Using an example, calculate the weighted cost of capital (WACC). What are some potential issues in using varying techniques for cost of capital for different divisions? If the overall company weighted average cost of capital (WACC) were used as the hurdle rate for all divisions, would more conservative or riskier divisions get a greater share of capital? Explain your reasoning. What are two techniques that you could use to develop a rough estimate for each division's cost of capital?

share whether you agree or disagree with their view of the use of the company's capital.Explain your reasoning.

1)

ALLEN

Corporations often use different costs of capital for different operating divisions. Using an example, calculate the weighted cost of capital (WACC).

As stated in the discussion post's instructions, corporations use different costs of capital for different operating divisions, which introduces us to the concept of the weighted average cost of capital, or WACC.WACC is the average after-tax cost of an organization's capital sources.These include sources like common stock, preferred stock, bonds, and other long-term debt.More simply put, WACC is the average cost of raising money (Folger, 2017).

Let's look at an example:

Sources of Capital:

Bonds = $5,261,649 (150,000 outstanding at 6% coupon rate)

Preferred Stock = $151,222 ($7.60 annual dividend, 125,000 shares outstanding)

Common Stock = $9,958,337 (100,000 shares outstanding, $5 per share)

TOTAL = $15,371,205

Tax rate is 30%

Step 1:

WACC = Wd Kd (1 t) + Wpfd Kpdf + We Ke

Wd= (value debt)/ (total value)

Wd = ($5,261,649)/($15,371,205) = 0.34 or 34%

Wpfd= (value preferred)/(total value)

Wpfd = ($151,222)/($15,371,205) = 0.01 or 1%

We= (value equity)/(total value)

We = ($9,958,337)/($15,371,205) = 0.65 or 65%

Step 2:

Kd=YTM on bonds

Price of Bonds = ($5,261,649)/(150,000) = $35.07

$35.07=$30/(1+YTM)1+$30/(1+YTM)2+...+$30/(1+YTM)30+$1,000/(1+YTM)30

YTM = 1.17 or 117% semiannually or 234% annually (incredibly unrealistic...oops!)

Kd=234%

PriceperShare = ($151,222)/(125,000) = $1.21

Kpfd = (Annual Dividend)/(Price per Share) = ($7.60)/($1.21) = 6.28 or 628% (ridiculous!)

Ke = D1/P0 + gn

Gn = 5%

D1 = D0(1+gn) = $5 (1.05) = $5.25

P0 = ($9,958,337)/(100,000) = $99.58

Ke = ($5.25)/($99.58) + 5% = 0.10 or 10%

Calculate:

WACC = (.34)(2.34)(1-0.30)+(0.01)(6.28)+(0.65)(0.10)

= (0.55) + (.06) + (0.07) = 0.68 or 68%

What are some potential issues in using varying techniques for cost of capital for different divisions?

There are three approaches to calculating Ke listed in our text: CAPM, Discounted Cash Flows, and Equity-Debt-Risk Premium approaches.All three approaches yield estimates that are relatively near to one another and are within the range prescribed by the equity debt premium.

One of the biggest issues with using WACC certain values, like cost of equity are not always the same, as a result of the different ways of calculating listed above.These can cause variation in the calculated values.WACC alone should not be used as a means of determining whether or not you should buy a particular investment.

If the overall company weighted average cost of capital (WACC) were used as the hurdle rate for all divisions, would more conservative or riskier divisions get a greater share of capital? Explain your reasoning.

If you use WACC as a hurdle rate for all division within an organization, it would be possible to approve projects that did not make sense to a particular division with higher risk tolerance than another.Like the example of the Campbell's Soup restaurants.Fast food is not really in the soup company's wheel-house and if pursued, it should be with great trepidation.

What are two techniques that you could use to develop a rough estimate for each division's cost of capital?

NPV and IRR

2)

JAIME

This was a difficult discussion for me and I'm not even sure if I did it right but here is what I got.

WACC is the weighted average cost of capital.It is used to determine how much it will cost to borrow money to fund a project.

The formula for WACC is

WACC=Wd*Rd(1-t)+We*Re

Wd=the proportion of the financing taken on by debt (bonds)

Rd = the cost of debt %

T = tax rate of the corporation

We = weight equity

Re = rate of expected return

Example:

$20 million of common stock to sell

Expected return of 10%.

Issue $6 million of debt

The cost of debt is 10%

Tax rate is 30%.

Value of company=$20+$6=$26

Weight debt = 6/26=.23

Weight equity = 20/26=.77

Wd=0.23

Rd=0.10

T=0.3

We=0.77

Re=0.10

WACC = 0.23*0.10(1-0.3) +0.77*0.10

WACC=23.8% (if my calculations are correct)

What are some potential issues in using varying techniques for cost of capital for different divisions?

Some potential issues in using varying techniques for cost of capital for different divisions there are a lot of assumptions. Interest rates can vary along with stock prices and tax rates. If the interest rate increases so does debt.

If the overall company weighted average cost of capital (WACC) were used as the hurdle rate for all divisions, would more conservative or riskier divisions get a greater share of capital? Explain your reasoning.

It can depend.The hurdle rate is the minimum rate of return on a project.If the rate of return is above the hurdle rate then the investment is more than likely good.If the rate of return is below the hurdle rate than the investment is not good.A risker division would be more likely to accept a rate of return at or a little above the hurdle rate where a more conservative division may not accept it.The risker division, since they take more risk could have more potential to get a greater share of capital however they could also loss a greater share of capital.

What are two techniques that you could use to develop a rough estimate for each division's cost of capital?

The cost of preferred stock technique equals the rate of return or annual dividend divided by its current market price.Preferred stock combines debt and equity and preferred dividends are fixed.Since dividends are paid with after-tax cash flows no tax adjustment is necessary (Hickman, Byrd, McPherson, 2013).

The cost of debt is the current yield to maturity on the company's bond and long term debt securities.This is useful in giving an overall rate being paid by the company to use debt financing.It give investors an idea of the riskiness of the company compared to others (Cost of Debt, n.d.).

3)

HEATHER

Thecost of capitalis the "rate of return that must be earned in order to satisfy investors" (Hickman, Byrd, & McPherson, 2013). Companies and corporations secure these funds, through debt or equity, in order to finance an investment. Cost of capital is used to evaluate new projects for companies and corporations.Weighted Average Cost of Capital(WACC), is "the discounted rate that may be found by incorporating the required returns (costs) for each capital source used to finance the firm" (Hickman, Byrd, & McPherson, 2013).Suppliers of capital expect a rate of return that compensates them for their risk in investing. WACC is the minimum return that a company or corporation must earn on an existing asset to satisfy its creditors, owners, and other providers of capital. "For any project, the weighted average cost of capital (WACC) is the after-tax required returns (interest on bonds or other types of debt is tax deductible, thus it lowers the effective cost of debt to the firm) on the firm's bonds, preferred stock, and common equity weighted by their proportional contribution to the project" (Hickman, Byrd, & McPherson, 2013, p. 10.2).

"The WACC is just the rate at which the Free Cash Flows must be discounted to obtain the same result as in the valuation using Equity Cash Flows discounted at the required return to equity" (Fernandez, 2011, p. 1). To calculate the weighted average cost of capital, companies and corporations multiply the cost of each individual capital for the desired investment, this may include loans, bonds, equity, and preferred stock, by the total percentage of total capital, and then add them all together. In order to calculate the most accurate WACC, companies and corporations must knew their specific rates of return required for each source of capital. Different sources of capital may have different percentages of taxation, or interest, which would all need calculated.

"The correct calculation of the WACC rests on a correct valuation of the tax shields" (Fernandez, 2011).

Corporations use different costs of capital for different operating divisions. Capital costs calculations would be, obviously, different between divisions. "Firms may reduce taxes paid to the government by using more debt in its capital structure. A corporation could conceptually avoid taxes altogether by financing exclusively with debt. If all cash flows were distributed to claimants in the form of interest payments, the government would collect no corporate taxes, because all interest would be paid before taxes" (Hickman, Byrd, & McPherson, 2013, p. 8.1). This can pose a risk of results being different, or inaccurate. It depends on the company's policies. While the debt and equity values can easily be determined, calculating the cost of debt and equity can be tricky. Problems involving different methods being used to calculate the cost of equity are that at least one component is an estimate. Terms of the risk free bond used in determining cost of debt may not always accurately match the terms of the company's debt. Companies and corporations cannot control interest rates, if the interest rates in the economy raise, the cost of debt increases because companies and corporations have to pay a higher interest rate to obtain debt capital. A higher interest rate increases the cost of common and preferred equity. Also, the perceived market risk for investors affects the cost of equity, and therefore affects the cost of debt.

"A pure-play is a publicly traded firm that engages primarily in the same line of business as the project being considered. If the pure-play firm has close to the same financing mix as the project, then the beta of this pure-play's assets may then be found and used as a proxy for the project's beta" (Hickman, Byrd, & McPherson, 2013, p. 10.3). By using a pure-play proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division.