Determining the Cost of Capital Essay

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ExxonMobil (Xom)

Would you recommend that ExxonMobil use a single company- wide cost of capital for analyzing capital expenditures in all its business units? Why or why not?

To start with, a single company-wide cost of capital implies that the firm uses one general cost of capital as the discounting rate for all of the capital expenditures within its business operations irrespective of whether they come from different departments. The recommendation for Exxon Mobil is that it should not make use of a single company-wide cost of capital when analyzing capital expenditures for all of its business units. Instead, the company should make use divisional cost of capital for each business unit independently when undertaking an analysis for capital expenditures (California State University, n.d).

This follows from the consideration of aspect of difference in the levels of risks involved, in the different business units. For Exxon Mobil, as every business unit makes a consideration for investment prospects, it has to employ an interest rate that is the cost of capital to appraise and assess the impacts of expected cash flows in the different time-spans. Using a single company-wide cost of capital implies aggregating the risk of the whole company (California State University, n.d).

If Exxon Mobil uses the single company-wide cost of capital, then this rate will be too high for some of its business units that have low risk and, at the same time, will be too low for the business units that are of high risk. As a result, the company may possibly accrue bad investments for those, which carry a high level of risk and turn down good investments for those that have a low level of risk. As such, it is imperative for the company to gain an estimation of the divisional rates that in turn, will signify the risk of each business unit differentially (California State University, n.

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d).

As Pratt and Grabowski (2010) observe, companies ought to make a valuation of any project or capital investment by making use of a discounting rate depicted by the risk features of the investment. The reason being, if the company employs a distinctive single company-wide cost of capital or discounting rate, then the company may, resultantly overinvest in business units that have a higher market beta compared to the core industry beta of the company. At the same time, the company may under-invest in business units that have a lower market beta compared to the core industry beta of the company (Kruger et al., 2011).

What is more, results of substantial differences in the discounting rate or costs of capital across the different business lines have indicated that making use of a single company-wide cost of capital is by and large not suitable or fitting. Using a single company- wide cost of capital….....

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