Divisional Cost of Capital: A Practical Approach

Abstract

According to one study [3], almost one-half of the industrial firms surveyed there used a single screening rate, such as the cost of capital, to evaluate investment proposals. Another study revealed that the use of a firm's cost of capital as a screening rate could lead to non-optimal decisions if the expected cash flows from the investment are not proportional to those of the firm and have different maturities and growth rates [9]. It follows that a firm's cost of capital may not be the appropriate screening rate to evaluate investment proposals in multi-division firms where the divisions have substantially different degrees of risk and financial characteristics from those of the parent company. Consequently, it is necessary to determine the cost of capital for each division. Divisional cost of capital has been addressed in finance textbooks by Brigham [3] and Van Horne [11], and in the finance literature by Bower and Jenks [1], Fuller and Kerr [4], Gordon and Halpern [5], and others [10, 13]. The studies cited use various derivatives of the capital asset pricing model (CAPM) to estimate the divisional cost of capital. A division is treated as though it were a separate company, and market data, when available, are used to derive the CAPM and the cost of capital. When market data for the division are not available, data from a similar company can be used as a proxy. Other studies dealing with systematic risk and debt capacity [1, 6, 7, 8] are also applicable here because the divisions may not have the same capital structure as their parent companies. This article presents a different approach to determine the divisional cost of capital. The method is based on the one used by Fuqua Industries, Inc., a multi-market manufacturing, distribution, and service company in the areas of recreational products and services, farm and home products, transportation, petroleum, and other operations. Stated otherwise,