Here are some notes on divisional and project cost of capital in detail:
- Divisional cost of capital (DCC) is the cost of capital for a specific division within a company. It is calculated by taking into account the risk of the division’s projects, the company’s overall capital structure, and the division’s financial leverage.
- Project cost of capital (PCC) is the cost of capital for a specific project. It is calculated by taking into account the risk of the project, the company’s overall capital structure, and the project’s financial leverage.
The DCC and PCC are important concepts in capital budgeting because they help companies to determine the correct discount rate to use when evaluating capital projects. The discount rate is the rate used to calculate the present value of future cash flows, and it is a key factor in determining whether or not a project is financially feasible.
There are a number of factors that can affect the DCC and PCC, including:
- The risk of the division’s or project’s cash flows: The riskier the cash flows, the higher the cost of capital.
- The company’s overall capital structure: The company’s capital structure can affect the cost of capital because the cost of debt is typically lower than the cost of equity.
- The division’s or project’s financial leverage: The division’s or project’s financial leverage can affect the cost of capital because the more debt a division or project uses, the riskier it becomes.
The DCC and PCC can be calculated using a number of different methods, including the following:
- Weighted average cost of capital (WACC): The WACC is the weighted average of the cost of debt and equity for the company as a whole. The DCC or PCC can be calculated by using the WACC and adjusting it for the risk of the division or project.
- Capital asset pricing model (CAPM): The CAPM is a model that uses the risk-free rate of return, the market risk premium, and the beta of the division or project to calculate the cost of capital.
- Appraisal method: The appraisal method is a subjective method that uses the judgment of experienced analysts to estimate the cost of capital.
The DCC and PCC are important concepts in capital budgeting, but they should not be used as the sole factor in making investment decisions. Companies should also consider other factors, such as the strategic fit of the project and the financial constraints of the company, when making investment decisions.