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Divisional Cost of Capital

Divisional Cost of Capital
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  • 1:36 Divisional Cost
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

How does a company know if an investment in the expansion of a specific division is a good idea? In this lesson, we'll examine the divisional cost of capital and how it can help business leaders make informed decisions about spending money for a segment of their business.

Cost of Capital

Carlos runs a company that offers cleaning services to commercial buildings, and also makes cleaning products that sell in stores. They have two major divisions: their consumer products division, in charge of the cleaning products, and their commercial services division, in charge of the commercial cleaning services.

Carlos wants to invest in a new, big marketing and advertising campaign for the consumer products. He really wants to get the word out that their products are great, but the campaign will cost his company money. Is it worth it?

What Carlos is facing is not unusual. It costs money to expand a business or start new projects. The cost of capital is an estimate of what investing in an asset or product will return versus what it would return if the money was invested in a different asset. In other words, it is an estimate of the minimum a project will have to return in order for it to be a good investment.

Companies often focus on what the company as a whole has to earn in order to determine the risk and feasibility of a project or expansion. But what if a company wants to take on a riskier, or less risky, project or expansion, one that might bring in more or less than the cost of capital says the company needs to bring in? And what if the project that a company wants to invest in only involves a specific part of the company?

That's the problem Carlos is dealing with now. When deciding about the advertising campaign, should he look at the cost of capital for the entire company, or just for the consumer products division? To help Carlos make that decision, let's explore the divisional cost of capital.

Divisional Cost

Carlos wants to invest in an advertising campaign for his company's consumer products division, but in making a final decision, he doesn't know whether to look at the risk and capital of his entire company, or just the consumer products division.

The risk of a specific division, which may be higher or lower than that of the company as a whole, should guide the decision-making about projects undertaken within that division. For example, Carlos' consumer products division might be riskier than their commercial services division, and therefore riskier than the company as a whole. If that's the case, it is the riskier data of the consumer products division that should influence Carlos' decision-making process.

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