ExxonMobil Oil Company Cost of Capital Order Instructions: Mini-Case 9-2 (Chapter 9)
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, including 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 at 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.
Instructions: In 600-750 words in length (not including title page and reference page), respond to the case below. Your paper must include at least two scholarly journal references (in addition to your book). Refer to the Writing Assignment Grading Criteria below for requirements in content, organization, writing style, grammar and APA 6.0 format.
ExxonMobil Oil Company Cost of Capital Sample Answer
ExxonMobil Cost of Capital
A company can use either cost of equity or cost of debt while acquiring finances for dehttps://mybestwriter.com/understand-and-managing-marketing-information/velopment. The cost of equity is used to finance the business for a short term basically less than one year or one year. The cost of debt is used to fund the business for a long-term period such as five years. Due to stiff competition, companies are multi-tasking their projects and they end up using both costs of equity and cost of debt to run their operations, (Hou, Van Dijk, & Zhang, pg. 507, 2012). ExxonMobil is one of the largest oil company in the world. The company has several daughter companies in the international market arena and it has merged and acquired companies such as XTO energy.
The company’s operations are segmented from upstream to downstream to chemical segment and global services. To finance all its operation and to maintain its market share globally, the company use both costs of equity and cost of debt as their cost of capital to run its operations. According to Brennan, Huh, &Subrahmanyam (2015) the company has recorded 5.6% as a cost of equity which it pays to the equity investors and it also has a cost of debt amounting to 4.01%. ExxonMobil cost of capital is resultant of the weighted average cost of capital (WACC). It means that a company’s cost of capital signify the hurdle rate which the organization is mandated to overcome before it creates worthiness, (Brennan, Huh, &Subrahmanyam, pg. 87, 2015).
Single company-wide cost of capital
ExxonMobil can use a single company-wide cost of capital for analyzing capital expenditures in all its business units. It is because the cost of capital is resulting from the weighted average. García, Saravia, &Yepes (2015) argued that when the organization uses WACC, it will help the top management to define the company’s “economic feasibility of expansionary opportunities and mergers”. When the company wishes to launch another new project or to advance on its current projects, the company should consider the level of risk as compared to the company total risk. If the project is of higher risk, the discount rate should be higher than that of the company’s WACC and if it’s of lower risk, the discount rate should be lower than that of company’s WACC, (García, Saravia, &Yepes, 2015) The Weighted Average Cost of Capital method gives a company an informed decision making when deciding on whether to finance a project or not due to risk factor.
Also, since ExxonMobil operate in the international market arena, the top management should understand the concept of capital budgeting in the foreign market is complicated that capital budgeting in the domestic market. Various factors can impact the company capital budgeting. For example the inflation rate of a foreign country. The inflation rate is in the capacity to affect the cash inflow and outflow of the project been initiated. Other factors such as exchange make the project complicated since all the calculation are done by the parent company them converted by the foreign exchange rate and since there is fluctuation in exchange rate, it becomes complex and this may force the company to use higher discount rate than overall company’s WACC, (García, Saravia, &Yepes, pg. 115, 2015).
In addition, the company may opt to analyze other companies that operate in the same line of business such as energy giant BP and be in a position to work out their WACC. The discount rate the company uses would be the same number that will be used by ExxonMobil. If it’s a virgin market, it becomes subjective and difficult to analyze the market risk.
Evaluating divisional costs of capital
Estimating costs of capital for ExxonMobil
ExxonMobil operates in the global market. It has a project in the arena and each project is associated with its costs. To approximate the cost of capital for each, the company should opt for using a beta. Beta is meant to weigh the macro risks of the business (Frazzini, & Pedersen, 2014). With this, the company can approximate the cost of equity for each project by using a given currency such as the euro risk-free rate and the equity premium in euro terms. Also, the company can approximate the default distributed by the company through the use of its variance in its securities prices. If its operation is within a market with sovereign default risk, the default can be distributed to the company business and this will result to the top management to use the marginal tax rate of the foreign country to approximate its after-tax debt.
The company can assign each division main core business by approximating their risks. It would use the unlevered beta for a given division as compared to that of the company. This will help the company to calculate the unlevered beta for each segment by incorporating all business they engage in and they will be able to estimate a cost of each division, (Frazzini, & Pedersen, pg. 25, 2014).
ExxonMobil Oil Company Cost of Capital References
Brennan, M. J., Huh, S. W., & Subrahmanyam, A. (2015). Asymmetric effects of informed trading on the cost of equity capital. Management Science
Frazzini, A., & Pedersen, L. H. (2014). Betting against beta. Journal of Financial Economics, 111(1), 1-25.
García, C. S., Saravia, J. A., &Yepes, D. A. (2015). The weighted average cost of capital over the lifecycle of the firm: is the overinvestment problem of mature firms intensified by a higher WACC?.
Hou, K., Van Dijk, M. A., & Zhang, Y. (2012). The implied cost of capital: A new approach. Journal of Accounting and Economics, 53(3), 504-526.