Question

In 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 a return on invested capital to approximately 15 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 1.8​, whereas distribution companies typically have equity betas of only 1.1. 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:

• The cost of debt financing is 7 percent before a marginal tax rate of 28 percent. You may assume this cost of debt is after any flotation costs the firm might incur.

• The​ risk-free rate of interest on​ long-term U.S. Treasury bonds is currently 7.2 ​percent, and the​ market-risk premium has averaged 4.5 percent over the past several years.

• Both divisions adhere to target debt ratios of 70 percent.

• 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

Calculation of Cost of Equity under Capital Assets Pricing Method (CAPM) = Risk free return + Beta*Market Risk Premium =

manufacturing division = 7.2%+1.8*4.5% = 15.30%

Distribution division = 7.2%+1.1*4.5% = 12.15%

After tax debt cost = 7*(100%-28%) = 5.04%

Debt Equity ratio 0.7:1

Weighted average cost of capital= Cost of Equity*weight of equity+after tax debt cost*weight of debt =

Manufacturing division = 15.30%*(1/1.7)+5.04%*(0.7/1.7) = 9%+2.075%= 11.075%

Distribution division = 12.15%*(1/1.7)+5.04%*(0.7/1.7) =

7.15%+2.075% = 9.225%

As from above calculation, it can be seen that cost of capital of manufacturing division is 11.075% and of distribution division is 9.225%, proposal to invest in distribution division will be good as it has lower cost of capital.