Question

n May of this year Newcastle Mfg. Company's capital investment review committee received two major investment proposals. One of the proposals was put forth by the firm's domestic manufacturing division, and the other came from the firm's distribution company. Both proposals promise internal rates of return equal to approximately

16

percent. In the past, Newcastle has used a single firm wide cost of capital to evaluate new investments. However, managers have long recognized that the manufacturing division is significantly more risky than the distribution division. In fact, comparable firms in the manufacturing division have equity betas of about

1.7 ,

whereas distribution companies typically have equity betas of only

1.3

Given the size of the two proposals, Newcastle's management feels it can undertake only one, so it wants to be sure that it is taking on the more promising investment. Given the importance of getting the cost of capital estimate as close to correct as possible, the firm's chief financial officer has asked you to prepare cost of capital estimates for each of the two divisions. The requisite information needed to accomplish your task follows:

bullet•

The cost of debt financing is

11

percent before taxes of

34

percent. You may assume this cost of debt is after any flotation costs the firm might incur.

bullet•

The risk-free rate of interest on long-term U.S. Treasury bonds is currently

7.7

percent, and the market-risk premium has averaged

4.94.9

percent over the past several years.

bullet•

Both divisions adhere to target debt ratios of

60

percent.

bullet•

The firm has sufficient internally generated funds such that no new stock will have to be sold to raise equity financing.

a. Estimate the divisional costs of capital for the manufacturing and distribution divisions.

b. Which of the two projects should the firm undertake (assuming it cannot do both due to labor and other nonfinancial restraints)? Discuss.

Answer 1

Answer:

a)Manufacturing division
Ke=Rf+beta(Rm-Rf)=7.7%+1.7(4.9%)	16.03%
Distribution division
Ke=Rf+beta(Rm-Rf)=7.7%+1.3(4.9%)	14.07%
Cost of DEBT after tax(same of both companies)
Cost of DEBT after tax=11%(1-34%)=11%(1-0.34)	7.26%
WACC for Manufacturing company
Source	Weights	coc%	Weighted cost
DEBT	60%	7.26%	7.7%
Equity	40%	16.03%	8.77%
WACC(7.7+8.77)			16.47%
WACC for distribution company
Source	Weighted	COC%	Weighted cost
DEBT	60%	7.26%	7.7%
Equity	40%	14.07%	6.37%
WACC(7.7+6.37)			14.07%
b) As WACC is lower for division company, therefore division company project to be selected.