Pioneer Petroleum Corporation
One of the critical problems confronting management and the board of Pioneer Petroleum Corporation was the determination of a minimum acceptable rate of return on new capital investments, The company’s basic capital budgeting approach was to accept all proposed investments with a positive net present value when discounted at the appropriate cost of capital. At issue was how the appropriate discount rate would be determined.
The company was weighing two alternative approaches for determining a minimum rate of return: (1) a single cutoff rate based on the company’s overall weighted average cost of capital, and (2) a system of multiple cutoff rates that reflected the risk-profit characteristics of the several
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Divisional Costs of Capital
The alternative proposed by the supporters of multiple cutoff rates in lieu of a single companywide rate involved determining the cost of capital for each division. The divisional rate would reflect the risks inherent in each of the economic sectors or industries in which the company’s principal operating subsidiaries worked. For example, the divisional cost of capital for production and exploration was 20%, and the divisional cost of capital for transportation was 10%. All the other divisional rates fell within this range. The suggestion was that these multiple cutoff rates determined the minimum acceptable rate of return on proposed capital investments in each of the main operating areas of the company and represented the rate charged to each of the various profit centers for capital employed. However, there were still areas of ambiguity. For example, it was unclear whether all environmental projects would have the same discount rate or the discount rate corresponding to the division.
The divisional cost of capital would be calculated using a weighted average cost of capital approach for each operating sector. The calculations would follow three steps: first, an estimate would be made of the usual debt and equity proportions of independently financed firms operating in each sector. Second, the costs of debt and equity given these proportions and sectors would be estimated in
required return of 24% for a project of it's risk. The dilemma for General Foods was to
Assumptions need to be made for the Cost of Equity. We used the corporate rate of 11.766%
How did you measure the cost of debt for each division? Should the debt cost differ across divisions? Why?
Mortensen’s cost of capital estimates are used for a variety of purposes at both the divisional and corporate levels. Examples include internal analyses such as financial accounting, performance assessment and capital budgeting, while others are used for strategic planning purposes such as merger and acquisition, as well as stock repurchase decisions (Luehrman and Heilprin, 2009, pg.1). When used at the divisional rather than corporate level, special consideration should be given to the fact that Midland’s divisions are not publicly traded entities, and therefore do not have individual Beta
Barb Williams and Rick Thomas, while attending an executive education course at a well-known business school, came across a case which involved calculating the cost of capital for Telus Corporation (Telus). Basic data such as the Balance Sheet, Income Statement, Data on Telus’ Common Stock, Market Index, and the Average Annual Returns in North American Capital Markets were provided. In order to calculate Telus’ cost of capital we need to calculate the company’s Cost of Equity, Cost of Debt, and Tax Rate along with their weighted cost and then apply these to the Weighted
Our estimated cost of capital, 20.81%, is lower than Ricketts’ expected return, 30%-50%, thus the investment is worthy. However, it’s higher than other pessimistic members’ expected return, 10%-15%, making the decision more complex and requiring further valuation。
Star Appliance is looking to expand their product line and is considering three different projects: dishwashers, garbage disposals, and trash compactors. We want to determine which project would be worth doing by determining if they will add value to Star. Thus, the project(s) that will add the most value to Star Appliance will be worth pursuing. The current hurdle rate of 10% should be re-evaluated by finding the weighted average cost of capital (WACC). Then by forecasting the cash flows of each project and discounting them by the WACC to find the net present value, or by solving for the internal rate of return, we should be able to see which projects Star should undertake.
In November 2001, the costs of required rates of return on debt in the capital market are as follows:
The mixture of debt-equity mix is important so as to maximize the stock price of the Costco. However, it will be significant to consider the Weighted Average Cost of Capital (WACC) as well so that it can evaluate the company targeted capital structure. Cost of capital (OC) may be used by the companies as for long term decision making, so industries that faced to take the important of Cost of capital seriously may not make the right choice by choosing the right project(Gitman’s, ).
a. What risk-free rate and risk premium did you use to calculate the cost of equity?
At first, WACC and CAPM was attempted to be used as a source of cost of capital. However, for WACC, there is no available proportion of debt and cost of debt for MW. For CAPM, no available data seems to support the acceptable
* We assume the cost of capital to be a stated annual rate to facilitate calculations;
Cost of Equity is the return that stockholders require for a company. A company’s cost of equity represents the compensation that the market demands in exchange for owning the assets and bearing the risk of ownership. Based on capital markets the cost of equity varies in direct relation to the assumed risk in that specific market. The distinctive of the firm is the sensitivity to market risk (β) which depends on everything from management to its business and capital structure. Therefore past performances and present conditions have a direct effect on the overall value. Applying calculations at a divisional level allows specified markets to be analysis based on present market conditions for that service or product. The formula used to calculate Cost of Equity is:
Assume the ROE and payout ratio stay the same for the next 4 years. After that competition forces ROE down to 11.5% and the payout increases to 0.8. The cost of capital is 11.5%. (15 points)
This article mainly discusses the cost of capital, the required return necessary to make a capital budgeting project worthwhile. Cost of capital includes the cost of debt and the cost of equity. Theorist conclude that the cost of capital to the owners of a firm is simply the rate of interest on bonds.