Firm-wide versus divisional cost of capital
This issue concerns any firm with two or more divisions that differ in risk from each other. As each division considers investment opportunities, it must use an interest rate (cost of capital) to evaluate the effects of expected cash flows in differing time periods. This interest rate is also called a "cutoff" rate. It is the minimum rate of return acceptable for projects in that division. The decision as to the appropriate cutoff rate is critical and is typically made at the highest levels of the firm. A firm-wide rate would be determined from the average risk of the whole firm. If a multidivisional firm uses a firm-wide cutoff rate, this rate will be too high for low-risk divisions and too low for high-risk divisions. The firm will accept bad high-risk projects and reject good low-risk projects. It is therefore necessary to estimate divisional cutoff rates that will reflect the risk of each division. In addition, because this process involves political rivalries within the firm, the approach used to justify these rates must be as comprehensible as possible.
The cost of equity capital for a firm is estimated from its beta using the security market line. Individual divisions typically don't have separate stocks and therefore beta can't be calculated for them directly. In order to estimate the beta of each division we first find stand-alone companies comparable to our division. The betas of these companies are then adjusted to remove the effects of financial leverage. The reason for this is to remove the variation between these comparable companies that is caused by variations in financial leverage. The average "unlevered" beta for each division is then calculated. This unlevered beta may then be used in the security market line, to estimate a "pure-equity" cutoff rate. (Theoretically, the unlevered beta should really be relevered at a rate appropriate for each division and averaged in with the cost of debt to obtain a weighted average cost of capital. We will not carry it any further than the "pure-equity" rate on the final however.)
Example: Comparable Company has a beta of .1.5 and a debt to assets of 46%. Assume a tax rate of 40%. Also assume that the risk free rate is 5% and the expected return on the market is 11%. Find its pure equity cost of capital.
First, compute the Debt to Equity= Debt to Assets/Equity to Assets. .85=.46/(1-.46)
Then, Unlevered Beta = Beta/[1+(1-Tax Rate)(Debt to Equity)] .99 = 1.5/[1+(1-.4)*(.85)]
The pure equity cost of capital is .109 = .05+ (.06*.99)