1. Single Company-Wide Cost of Capital

Using a single company-wide cost of capital for all business units at ExxonMobil is not recommended.

While a single cost of capital can simplify calculations, it fails to account for the distinct risk profiles of different business units. ExxonMobil’s operations span a wide range of activities, from the volatile upstream exploration and production to the more stable downstream refining and marketing. Each business unit faces unique risks, including commodity price fluctuations, regulatory environments, and competitive pressures.

A single cost of capital would mask these differences, leading to suboptimal investment decisions. Overinvesting in high-risk projects or underinvesting in low-risk projects can erode shareholder value.

1. Divisional Costs of Capital

Estimating divisional costs of capital requires a more nuanced approach.

1. Weighting the Capital Structure:

• Debt-to-Equity Ratio: Determine the optimal capital structure for each division based on factors like business risk, tax rates, and financial flexibility.
• Market Value Weights: Use market values of debt and equity to reflect the true economic proportions of each component.
• Target Capital Structure: Consider the division’s desired long-term capital structure to align with its risk profile.

2. Cost of Debt:

• Yield to Maturity: Calculate the cost of debt based on the yield to maturity of the division’s outstanding debt.
• Credit Rating: Adjust the cost of debt based on the division’s credit rating to reflect default risk.
• Tax Shield: Consider the tax implications of debt financing.

3. Cost of Equity:

• Capital Asset Pricing Model (CAPM): Estimate the cost of equity using the risk-free rate, market risk premium, and the division’s beta.
• Dividend Growth Model: If applicable, use the dividend growth model to estimate the cost of equity.
• Comparable Company Analysis: Analyze the cost of equity for similar companies in the same industry.

4. Weighted Average Cost of Capital (WACC):

• Calculate the WACC for each division by multiplying the cost of each capital component by its weight in the capital structure and summing the results.

Challenges and Considerations:

• Data Availability: Obtaining accurate data on divisional debt and equity can be challenging.
• Beta Estimation: Estimating betas for individual divisions can be complex, especially for conglomerates like ExxonMobil.
• Risk Assessment: Accurately assessing the risk profile of each division is crucial for determining the appropriate cost of capital.
• Transfer Pricing: Intercompany transactions can distort financial data, making it difficult to isolate divisional performance.

By employing a divisional cost of capital approach, ExxonMobil can make more informed investment decisions, allocate capital efficiently, and improve overall shareholder value.