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Suppose your firm wanted to expand into a new line of business quickly through an existing division of the firm, and that management anticipated that the new line of business would constitute over 80 percent of your firm’s operations within three years. If the expansion was going to be financed partially with debt, would it still make sense to use the firm’s existing cost of debt, or should you compute a new rate of return for debt based on the new line of business? Explain why the divisional cost of capital approach may cause problems if the development of this line of business was assigned to the wrong division within the firm.

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Jamar Ferry
Jamar FerryLv2
28 Sep 2019

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Please show all calculations, on paper preferably. Have posted this before and all calculations weren't there. Need for them explaination process and to get a better understanding!

Tucker Inc. makes home kitchen and bathroom faucets. The company was founded 50 years ago by Joseph Tucker and his granddaughter Jill is now chief financial officer. Senior management is contemplating starting a new line of faucets designed specifically for restaurants. Tucker’s marketing department has spent $225,000 on research in this area and is convinced this will be a viable product line for the company. The equipment, facilities, and departments for the new line must be financed and Jill is working on computing the appropriate cost of capital to be used in computing the present value of the line’s future cash flows. Here are the facts facing the firm:

1) Tucker, Inc. has a history of maintaining its target capital structure over the long run.

2) The firm’s outstanding semiannual noncallable bonds carry a 4% coupon rate, mature in 12 years, and are trading in the market today at a price of $975 for each $1,000 face value. The firm has 1,000 bonds outstanding.

3) Tucker’s beta is 1.20 and its last dividend, just paid yesterday, was $4.00. The company expects its earnings to grow at 4% per year into the foreseeable future. The market risk premium is 5%. The risk free rate is 2%. The stock is fairly valued. The firm has 28,125 shares of common stock outstanding. The firm is going to have to issue new shares of common stock to finance the new product line. Common stock flotation costs are 4%.

4) The new product line is slightly riskier than Tucker’s existing business and will require an addition 1.25% required return over the firm’s weighted average cost of capital.

5) The firm’s tax rate 35%.

Assume you are the financial manager working for the CFO. The CFO wants you to recommend an appropriate weighted average cost of capital for Tucker, Inc. and the new product line. As a financial manager, write a letter to Jill, the CFO, discussing your recommendations and the issues surrounding your estimates. Attach your supporting calculations, appropriately labeled so that the CFO can verify your computations. State any relevant assumptions you made. The letter must be typed with 12-point font and should be one page or less. The calculations do not have to be typed, but need to be legible.

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. 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.

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. 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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