Determining the Cost of Capital

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.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 would cause different departments to miss out on fitting projects as their discounting rate might be lower or higher in comparison to the overall company cost of capital.

If you were to evaluate divisional costs of capital, how would you go about estimating these costs of capital for ExxonMobil?

To start with, it is very important for Exxon Mobil to as certain that there exists certain difference between the cost of the different business units and the cost of the company when looked at, in its entirety. This is important as the cost of the business units or departments might vary significantly as opposed to the cost of the firm (Pratt and Grabowski, 2010).

As such, the approach that the Exxon Mobil ought to undertake, is that of utilizing the weighted average cost of capital approach (WACC). In particular, this methodology is deemed to be appropriate for Exxon Mobil, because by utilizing the weighted average cost of capital, Exxon Mobil will possess the ability to take account of or incorporate the costs from all projects and capital investments, both the extra ones and the prevailing ones (Pratt and Grabowski, 2010).

In addition, by deploying this methodology, Exxon Mobil will be able to take into account every discounting rate that is rated from each project or capital investment it possesses. What is more, by making use of this methodology, Exxon Mobil will be able to make necessary arrangements for the differences in risk. Such an undertaking will make it easy for the company to avoid accepting investments that are too risky or turn down the capital investments which are may actually be safe (Pratt and Grabowski, 2010).