Overview of Divisional Cost of Capital
Divisional cost of capital is the required rate of return for a division of a corporation that has risk characteristics that differs from the risk characteristics of the overall corporation.
Application of Divisional Cost of Capital
The term divisional cost of capital is one of the many important costs of capital that are incurred by a company when it is running its business. The concept of divisional cost of capital comes into operation if a particular company has more than one business wing.
Having more than one business division means that the company needs to spend a significant amount of money in all these various divisions.
Approaches of Divisional Cost of Capital
There are a few approaches that are helpful in the context of finding out the divisional cost of capital of a particular project.
The following methods may be enumerated as well in the context of divisional cost of capital:
- The Subjective Approach
- The Pure-Play Technique
# The Pure Play Technique
The pure-play technique is one of the various methods that are used to calculate the divisional cost of capital of a particular project. It is used on an extensive scale.
Following are some of the basic steps that are followed in the pure-play technique:
- Locating companies that can be compared.
- Calculating the equity betas for the business entities that can be equated.
- Approximating the asset betas for the comparable business organizations.
- Determining the beta of the division.
- Determining the cost of all-equity cost of capital of the particular division.
- Finding out the equity cost o capital of the particular division.
- Estimating the cost of capital of the division.
# The Subjective Approach
At certain times the companies adopt the subjective approach to measure the divisional cost of capital of a particular project. The main reason behind this is that the companies cannot always provide rates of discount for each and every project in an objective manner. In such cases the companies normally adopt a subjective way with regards to the total weighed average cost of capital.
# The Spanning Approach
The spanning approach is a third way to estimate the divisional cost of capital. It assumes that the return of a portfolio that spans the systematic cash flow variability of an asset is an unbiased estimate of that asset’s risk and required return. Implementation of the spanning approach requires development of systematic cash flow variability measures both for a large sample of publicly traded firms and for the target asset (the non-traded division). Spanning portfolios of the traded firms that replicate the covariance properties of the target asset’s cash flows are then formed. The anticipated return for a portfolio that spans the target asset’s systematic cash flow variability is expected to equal the division’s required return.
The spanning approach has advantages over both subjective and pure-play techniques. It preserves the logic of each while avoiding the various implementation problems. Like the subjective technique, the spanning approach assumes the systematic risk characteristics of a division relate to an observable accounting measure–cash flow. Like the pure-play approach, a spanning portfolio plays a proxy role to provide an estimate of the required return of the division (target asset). It has an advantage in that many spanning portfolios or pure-play proxies can be formed from even a small sample of publicly traded firms.