Introductory Corporate Finance: Cost of Capital - Divisional Cost of Capital, Pure Play Approach Subjective Adjustments

What This Is

Divisional Cost of Capital (DCC) is a method used to estimate the cost of capital for a specific business segment or division within a company. This approach is essential in corporate finance as it allows companies to evaluate the profitability of individual divisions and make informed decisions about resource allocation. For example, consider a conglomerate like General Electric (GE), which operates in various sectors such as aviation, healthcare, and energy. By applying the DCC approach, GE can estimate the cost of capital for each division and assess its contribution to the overall company performance.

Key Formulas & Models

• DCC = rd × (1 - T) + rps × (1 - T) + re – divisional cost of capital; used as discount rate for divisional cash flows.
  • rd: cost of debt for the division
  • T: tax rate
  • rps: cost of preferred stock for the division
  • re: cost of equity for the division
• WACC = wd × rd(1-T) + wps × rps + we × re – weighted average cost of capital; used as discount rate for the company.
  • wd: proportion of debt in the company's capital structure
  • wps: proportion of preferred stock in the company's capital structure
  • we: proportion of equity in the company's capital structure
• DOL = Q(P-V) / (Q(P-V)-F) – degree of operating leverage; measures EBIT sensitivity to sales.
  • Q: sales
  • P: price per unit
  • V: variable costs per unit
  • F: fixed costs
• DFL = (EBIT - I) / (EBIT - I + F) – degree of financial leverage; measures EBIT sensitivity to interest payments.
  • EBIT: earnings before interest and taxes
  • I: interest payments
  • F: fixed costs
• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – measures the maximum rate at which a company can grow without issuing new equity.
  • ROE: return on equity
  • Retention Ratio: proportion of earnings retained by the company
• Free Cash Flow = EBIT - Capital Expenditures - Change in Working Capital – measures the cash generated by a company's operations.
  • EBIT: earnings before interest and taxes
  • Capital Expenditures: investments in property, plant, and equipment
  • Change in Working Capital: changes in accounts receivable, inventory, and accounts payable

Step-by-Step Calculation

1. Estimate the cost of debt for the division (rd) using the company's credit rating and market interest rates.
2. Estimate the cost of preferred stock for the division (rps) using the company's preferred stock price and dividend yield.
3. Estimate the cost of equity for the division (re) using the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model (DDM).
4. Calculate the divisional cost of capital (DCC) using the formula: DCC = rd × (1 - T) + rps × (1 - T) + re.
5. Use the DCC as the discount rate for divisional cash flows.
6. Calculate the weighted average cost of capital (WACC) for the company using the formula: WACC = wd × rd(1-T) + wps × rps + we × re.

Common Mistakes

1. Mistake: Using book value instead of market value for WACC.
   • Correction: Use market value for WACC to reflect the current market capital structure.
2. Mistake: Ignoring flotation costs when calculating WACC.
   • Correction: Include flotation costs in the WACC calculation to reflect the true cost of capital.
3. Mistake: Confusing sunk cost with opportunity cost.
   • Correction: Use opportunity cost when evaluating investment decisions, not sunk cost.
4. Mistake: Not considering the impact of taxes on WACC.
   • Correction: Include the impact of taxes on WACC to reflect the true cost of capital.

Exam / CFA Tips

1. Tip: Be able to distinguish between the pure play approach and the subjectivity approach to estimating DCC.
2. Tip: Understand the difference between the degree of operating leverage (DOL) and the degree of financial leverage (DFL).
3. Tip: Be able to calculate the sustainable growth rate using the ROE and retention ratio.
4. Tip: Understand the importance of considering taxes when estimating WACC.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, tax 25% – compute DFL.

Answer: DFL = (10 - 2) / (10 - 2 + 2) = 0.8

Explanation: The company's DFL is 0.8, indicating that its EBIT is sensitive to interest payments.

Last-Minute Cram Sheet

1. DCC: Divisional Cost of Capital
2. WACC: Weighted Average Cost of Capital
3. DOL: Degree of Operating Leverage
4. DFL: Degree of Financial Leverage
5. ROE: Return on Equity
6. Retention Ratio: Proportion of earnings retained by the company
7. Free Cash Flow: EBIT - Capital Expenditures - Change in Working Capital
8. In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
9. The cost of equity is the return required by investors for bearing the risk of equity ownership.
10. The weighted average cost of capital (WACC) is the minimum return required by investors for bearing the risk of the company's capital structure.