Abstract

Estimating the Divisional Cost of Capital for Diversified Companies -

An Empirical Comparison of two Methods

J. Bufka, D. Schiereck

Universität Mannheim

Judging a company´s investment possibilities requires the valuation and the comparison of uncertain future cashflows. Based on the net present value calculation, the weighted cost of capital, derived from capital-market theory, forms a concept for the fixing of the discount rate, necessary for the valuation that is broadly accepted but not always easy to implement.

After having met implementation problems, especially for divisions of broadly diversified companies, practical ways of determining the divisional cost of capital are now being discussed along with the approaches that are based on capital-market theory. The fact that a subjective estimation of the individual risk of a division is drawn from various criteria is substantial. These approaches are comparatively simple as far as their application is concerned, but we know of no study that treats these approaches empirically with regard to their evidence.

This study provides an empirical survey analyzing the extent to which practical approaches are suitable to correctly adjust the risk for a division according to capital-market theory. The risk measures of two practical approaches discussed in literature and used in industry are ascertained for a sample of German listed companies and compared with common risk measures that are based on capital-market theory.

We will show that practical approaches are only partly suitable for the evaluation of divisional risk. But at least one of them seems to offer an intuitively comprehensible and comparatively uncomplicated approach helping to establish a risk-adjusted return on equity.