CF Session 9 - Divisional Cost of Capital

Avijit Bansal
Indian Institute of Management Calcutta

January 23, 2023

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A quick recap of implications of CAPM

Risk-return relationship as measured by β is linear (huge advantage)

βp = w1 β1 + · · · + wn βn

Risk of a portfolio is the weighted average of the β of its constituents

Expected return on a portfolio is E [Rp ] = rf + βp (E [Rm ] − rf )

Will this result hold for a multi-division firm with the revenue of each division having
different sensitivity to the un-diversifiable market risk?

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β of a multi-division risk

β of a multi-division firm should ideally be a weighted average of the beta of

the individual divisions

An investor does not care about diversification within the company

Investors can invest in single-division firms on their own and adjust the weights
in their portfolio

Hence, investors parking their money in a multi-division firm should be

appropriately compensated for all the risk they are bearing

Will this create problems of the managers?

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Example

Consider a multi-division firm with divisions A and B, each generating 50% of

FCFF. The company is all equity-financed

Assume total FCFF is 100

Division A operates FMCG business

Division B operates the Hospitality business

Average FMCG company Average Hospitality company

βAsset = 0.75 βAsset = 1.25

rf = 2%, MRP = 5% and re = 5.75% rf = 2%, MRP = 5% and re = 8.25%

What is the Asset Beta and re for the firm?

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Example Continued

Average FMCG company Average Hospitality company

βAsset = 0.75 βAsset = 1.25

rf = 2%, MRP = 5% and re = 5.75% rf = 2%, MRP = 5% and re = 8.25%

50 50
Value = = 869.6 Value = = 606
5.75% 8.25%
869.6 606
Weight = = 58.9% Weight = = 41.1%
869.6 + 606 869.6 + 606

βAsset = 58.9% × 0.75 + 41.1% × 1.25 = 0.96

re = 2% + 0.955 × 5% = 6.78%

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Example
Consider a multi-division firm with divisions A and B, each generating 50% of
FCFF. The company is all equity-financed

Division A operates FMCG business

Division B operates the Hospitality business

βAsset = 0.96, and re = WACC = 6.78%

Note: weights are based on how much each division contributes to the overall
market value of the firm

Average FMCG company Average Hospitality company

βAsset = 0.75 βAsset = 1.25

rf = 2%, MRP = 5% and re = 5.75% rf = 2%, MRP = 5% and re = 8.25%

The company can invest in a new project with an expected return of 8%. Should
the company undertake the project and make the necessary investments?
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Example (continued)

You should ask whether the project is in FMCG or Hospitality.

The opportunity cost of capital depends on the use of that capital

Not all projects have the same risk, hence evaluating them using the same
standard will be sub-optimal

Hospitality business is riskier than FMCG; hence it requires a higher return

Using a company-wide WACC would lead to an incorrect assessment of the

potential of a project

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Example (continued)

An FMCG project with return of 6.5% is a good investment as hurdle rate of

such projects is 5.75%

A hospitality project with return of 8% is a bad investment as hurdle rate for

such projects is 8.25%

If projects are evaluated using company-level WACC of 6.78% then one would
reject the first project and take on the second project

Put another way, a company may end up taking sub-optimal riskier projects
while rejecting profitable safe investments

Over a period of time, this practice can make the overall firm riskier and make
the equity investors worse-off

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What are the challenges in using division level risk
measure?

Convincing the divisional managers. Imagine which divisional manager would

like their division to be labeled “riskier” and would be okay when asked to
deliver higher return

Estimation of the β. While it is simpler to estimate beta of a company by

running regression, it is not so easy for divisions. You observe return on a stock
of a company and not the break-up of division wise returns

Hence, estimating divisional level β is difficult

We observe debt at a company level. Project level division of debt is not

available on the financial statements. Hence, estimating D/V ratio of divisions
is difficult.

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How do we estimate the division-level cost of
capital

Identify the industries/businesses that a firm operates in

Identify the publicly traded comparable firms in those businesses. Ideally,

single-division firms operating in only one business

Find out the βLevered of all the comparable firms

Estimate the βUnlevered of these comparable firms

Take an average of the βUnlevered of comparable firms. This gives the asset beta
of the particular business that reflects the risk devoid of any impact of leverage

Compute the levered beta of the division using the appropriate debt-to-equity
ratio

Compute the cost of capital of the division using the estimated levered beta
from the above step

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Financial leverage

The risk to the equity shareholders increases when the firms take on more debt,
as they are residual claimants

The probability of bankruptcy also increases with high leverage

D
h i
βLevered = βUnlevered 1 + (1 − T )
E

Regression analysis provide βLevered , also known as equity beta (βEquity )

βUnlevered is also known as the asset beta (βAsset )

βUnlevered captures the risk of the operations of the firm after removing the
impact of leverage

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Flotation Costs

While issuing equity or debt, the company have to bear expenses such as legal
expenses, the fee charged by the underwriter and advisers, etc.

Many people account for these expenses by increasing the WACC, which is an
incorrect practice

Ideally, flotation costs should be treated as part of the investment amount

without disturbing WACC

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References I

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