The Cost Of Capital Budget

I do not think it is proper. Since hurdle rate is the key factor to determine whether we should accept a project, it is concerned with a specific investment opportunity belonging to a division. As we can see in Table 1, each of Midland`s divisions had its own target debt ratio. Those

Midland should not rely on a single corporate hurdle rate for evaluating investment opportunities across all divisions because each division is subject to fundamentally different forces such as political volatility, and high future expenditures. For example, R&E is expected to have capital expenditures in excess of $8 billion over the years 2007 and 2008 while worldwide refining capabilities are expected to decrease leading to possible investments in this division of Midland. The Exploration and Production division faces an entirely different set of challenges as oil reserves become more difficult to reach as in the case of arctic and deep water drilling operations, and consequently more expensive to exploit. In addition, political instability has become increasingly prevalent in investment considerations as oil production in areas such as the Middle East and Africa have grown. Civil and political upheaval in these regions threatens disruption of oil production and lead to greater volatility of prices (pg.2).

Capital structure decision will be affected when each division raises its own debt. Since the divisions are free of the parent company’s structure- permitting each division to set up their target debt ratio close to the industry average. This leads to each division setting a high debt ratio to achieve a lower hurdle rate.

1. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not? 2. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and justify your assumptions. 3. Calculate the costs of equity using CAPM, the dividend discount model, and the earnings capitalization ratio. What are the advantages and disadvantages of each method?

1. Most publicly traded corporations are required to submit 10Q (quarterly) and 10K (annual) reports to the SEC detailing their financial operations over the previous quarter or year, respectively. These corporate fillings are available on the SEC Web site at www.sec.gov. Go to the SEC Web site, follow the “Search for Company Filings” link, the “Companies & Other Filers” link, enter “Dell Computer,” and search for SEC filings made by Dell. Find the most recent 10Q and 10K and download the forms. Look on the balance sheet to find the book value of debt and

Capital budgeting risk can be measured from three perspectives. First, the project standing alone risk, is a project’s risk ignoring the fact that much of this risk will be diversified away. Secondly, would be the project’s contribution - to - firm risk, which is the amount of risk that the project contributes to the firm as a whole, thus, considering the fact

As a dedicated furniture maker and businessman, a clear understanding of the techniques used to assist in capital budgeting is important. There are several techniques used, each having advantages and disadvantages. Within this recommendation, the advantages and disadvantages of each technique will be briefly discussed. Additionally, discuss how each technique will assist in determining the desirable capital budget technique to recommend. Concluding with a course of action Mr. Navallez should take, along with calculation to support the recommended course of action.

Mrs Barbara Kravitz states to use the corporate target capital structure of 45 percent debt for each division. Hence, this unique capital structure implies not to account for different application and management in the several divisions. Moreover, some divisions can be threatened not being competitive in their market. This is, because divisions operate in diverse markets with differing market conditions. So the risks are not assigned to the divisions of the company but to the corporate average. For instance, low-risk divisions have to accept higher a higher cost of capital, whereby high-risk divisions have to pay less for their risk relative to the market, i.e. this approach does not account for risk-adjusted cost of capital.

ANS: Different projects should be set according to their risks and expected returns, even though they are in a given division. The various situation and market fluctuation for each project might lead to different returns. So Pioneer should set the cost of capital and weights distinctly among those projects. Because Beta represents the risk of a project and different projects show different risks, Beta used to calculate the CAPM should be determined depending on the risks. In addition, in determination of weights of debt and equity, they should also consider differently because initially Pioneer set half and half. But we believe in the future capital budgets, being more specific when setting the weight instead of just evenly distributed would be more reasonable.

Midland should not rely on a single corporate hurdle rate for evaluating investment opportunities across all divisions because each division is subject to fundamentally different forces such as political volatility, and high future expenditures. For example, R&E is expected to have capital expenditures in excess of $8 billion over the years 2007 and 2008 while worldwide refining capabilities are expected to decrease leading to possible investments in this division of Midland. The Exploration and Production division faces an entirely different set of challenges as oil reserves become more difficult to reach as in the case of arctic and deep water drilling operations, and consequently more expensive to exploit. In addition, political instability has become increasingly prevalent in investment considerations as oil production in areas such as the Middle East and Africa have grown. Civil and political upheaval in these regions threatens disruption of oil production and lead to greater volatility of prices (pg.2).

For starters, we cite the fact that the existing corporate rate of 15% is simply outdated (ten years old) and the market for the cost of capital has changed significantly in recent years (e.g., 30-year treasury bonds currently yield 4.73% vs. 10% when existing corporate rate was calculated). Additionally, by calculating WACC, Mr. Prescott will have clarity with respect to how the market views the risk associated with the company’s assets and it will also help with calculating the required return for this and future capital budgeting projects. As for the latter, the required return is a critical data input and reference point that Mr. Prescott will need when calculating the net present value (NPV) of the project. Finally, when making capital budgeting decisions with NPV and internal rate of return (IRR) it is imperative that the business managers have knowledge with respect to the applicable discount rate and the data inputs/variables used to compute it. In this case, Mr. Prescott was lacking critical knowledge associated with the existing corporate cost of capital rate; therefore he lacked the confidence needed to apply it and in good conscious had to calculate a new WACC.

The cost of equity can be calculated by using the capital asset pricing model (CAPM). CAPM requires that a market risk free rate, the market risk premium, and the beta for the company. The market risk premium (6%) and the company beta (1.1) is given directly and can be seen in tables 2 and 3 below. Government bonds are used for the risk free rate. Since 10 year corporate bonds are used for the cost of debt, the 10 year Treasury Bond of 5.60% will be selected as the risk free rate. The 10 year bonds are also a good match for the project duration, which is between 5 and 10 years. The cost of equity of 11.20% is than calculated as follows:

When people hear the term capital budgeting, they usually focus on the budgeting part of the term rather than the capital portion. Actually, capital is the more important aspect because it shows you that you are evaluating a larger expenditure that will be capitalized—in other words, depreciated over time. Remember, a capital expenditure can be many things—a large copying machine, an automated assembly line, a building, or the ultimate in capital budgeting—the acquisition of another entity. What is important about capital budgeting is it allows you to analyze one or more projects so you can intelligently and strategically decide on which project you wish to

In order to determine the beta and weight of debt for the Products and Systems segment, we averaged the Equity Beta and and the Mkt. Val. Debt/Capital for the Telecommunications Equipment and Computer and Network Equipment industries.

The concept of capital budgeting is critical for the livelihood as it involves the guidance and control for the future success of the company.