ExxonMobil ( XOM) is one of the half- dozen major oil companies in the world. The firm has four primary operating divisions ( upstream, downstream, chemical, and global services) as well as a number of operating companies that it has acquired over the years. A recent major acquisition was XTO Energy, which was acquired in 2009 for $ 41 billion. The XTO acquisition gave ExxonMobil a significant presence in the development of domestic unconventional natural gas resources, includ-ing the development of shale gas formations, which was booming at the time. Assume that you have just been hired to be an analyst working for ExxonMobil’s chief financial officer. Your first assignment was to look into the proper cost of capital for use in making corporate investments across the company’s many business units.
a. 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?
b. If you were to evaluate divisional costs of capital, how would you go about estimating these costs of capital for ExxonMobil? Discuss how you would approach the problem in terms of how you would evaluate the weights to use for various sources of capital as well as how you would estimate the costs of individual sources of capital for each division.
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Companies usually draw their sources of capital from investors who ae interested in getting back value for their investment. This means that a company has to be judicious and calculative in the way that it makes its investment decisions. ExxonMobile is a big company that has many divisions that have their independent investment plans and initiatives. Investment plans usually come with their associated risks that have to be estimated as they have a direct bearing on value creation efforts of the overall company. Following the acquisition of XTO that farther adds to the massiveness of Exxon Mobile, the way of determining the proper cost of capital to inform the investment decisions needs reevaluation. The reevaluation will have to employ tools that consider the overall company investment priorities as well as the divisional aspects that impact on the process of analyzing capital expenditures. The weighted average cost of capital (WACC) will be discussed as the recommended financial tool for capital investment decision-making at Exxon Mobile.
Investment and expansionist decisions based on WACC usually do risk comparisons. Directors of divisions usually assess the level of risk at their areas of jurisdiction vis-à-vis the overall risk estimates of the firm. This requires that the WACC be determined first. WACC usually has two facets. The investor and the company. WACC analyses the returns that flow in and which count as value for investors. At the overall firm level, the return earned is not supposed to be lesser than the WACC as this would not translate to value creation (Kruger et al., 2015). Accordingly, Exxon has to use WACC which is a company-wide cost of capital tool. The tool results in the estimation of a level of risk that serves as a threshold above or below which, the worth of investment can be judged (Berry et al., 2014). The risk differential that WACC yields as a company-wide cost of capital tool if ignored in efforts to make investment decisions may lead to the undertaking of a project founded on premises that are invalid.
Using the company-wide tool such as by means of WACC makes it easy to make an investment decision for projects with risks that are similar. A new project can sometimes have an equal risk implication as the projects that are already being undertaken. WACC therefore serves as a benchmark that establishes the line of acceptance or rejection of an investment choice. For XOM acquiring XTO, the venture is the same as it deals with energy for both. This leads to the presumption that the level of risk in acquiring XTO is the same as the one that is in the operations of XOM. However, the WACC establishes a benchmark that is a hurdle that prompts the consideration of the real worth of undertaking the project. This prevents carrying on to undertake a project based on assuming the similarity of risks. Still, WACC can be used to determine projects that have dissimilar risks (Kruger et al., 2015). Calculations in this respect use WACC as a metric of performing analyses with respect to capital structure and this yields a standard of judgment of project feasibility.
Using a company-wide tool may result to a benchmark estimate that is too high as to be misleading for divisions that are low-risk. The benchmark may also be too low for the divisions that are high risk. This leads to the danger of having to accept investments that are high-risk but bad while rejecting those that may be good only that they were found based on the benchmark to be low-risk. This is the reason why calculating divisional cut offs is necessary. This will reflect the risk for a respective division in the entire firm (Berry et al., 2014). To analyze divisional costs of capital at XOM, calculations of beta have to be calculated.
However, calculating beta for divisions is not direct and instead uses relativity by looking at a company that is stand-alone but has comparative characteristics similar to those of a particular XOM division. Adjustments to the betas of the found comparative standalone companies have to be manipulated in order to rid effects due to financial leverage. This is done to synchronize the division and the standalone company by ridding variations between them that usually are based on varying financial leverage. This allows the average beta that is “unlevered” to be derived for the division or each division for the case of XOM. The figures for divisional cost of capital have to be in terms of market value.
However, WACC remains an instrumental tool since it is key
to various investment analysis calculations. For net present value, WACC is
essential as discount or hurdle rate in the calculations. This is with respect
to the fact that cash flows that are discounted by means of WACC just as is the
case with terminal values. Calculating economic value added also uses WACC as
the cost of capital which makes it an essential tool. However, it calls for
high-level accuracy as any inaccuracy leads to an investment decision that is
faulty. This may spell losses, and loss of value that will drive investors
Krüger, P., Landier, A., & Thesmar, D. (2015). The WACC fallacy: The real effects of using a unique discount rate. The Journal of Finance, 70(3), 1253-1285.
Berry, S. G., Betterton, C. E., & Karagiannidis, I. (2014). Understanding Weighted Average Cost of Capital: A Pedagogical Application. Journal of Financial Education, 115-136.