The State Oil Company of Azerbaijan Republic (SOCAR) is an integrated oil company headquartered in Baku, Azerbaijan, and has large operations in nearby regions.

Historically, SOCAR did not spend a great deal of time thinking about the opportunity costs of capital for each of its divisions in the South Caucasus and used a company-wide weighted average cost of capital of 15 percent for all new capital investment projects. However, recent changes in its businesses and in oil prices have made it abundantly clear to SOCAR’s management that this is not a suitable approach. Consider the following examples:

a. Ayan Teh is the company’s regional manager, and he argues that the cost of capital should be raised up to 20 percent as the company’s investors face increased risk. He has calculated 20 percent to be the highest rate of return for the most risky region. Discuss SOCAR’s current position regarding cost of capital. Do you agree with Ayan? Why or why not?

b. The company’s financial manager, Leila Haddad, has a different point of view. She argues that even after considering the unfavorable developments for SOCAR, charging the company-wide cost of capital at 20 percent for all the regions might be too high and is not reasonable, and so the company needs to introduce various costs of capital for the different regions. Do you agree with Leila? Explain your answer.