Question

(Divisional costs of capital and investment decisions​) 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 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 1.2. 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 12 percent before taxes of 37 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 7.6 percent, and the​ market-risk premium has averaged 4.8 percent over the past several years.

• Both divisions adhere to target debt ratios of 50 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

a). Weight of debt (wd) = 0.5; weight of equity (we) = 0.5

Cost of debt = 12%

After-tax cost of debt (kd) = 12%*(1-tax rate) = 12%*(1-37%) = 7.56%

Manufacturing division cost of equity (ke) = risk-free rate + beta*market risk premium = 7.6% + (1.7*4.8%) = 15.76%

Cost of capital for the manufacturing division = (we*ke) + (wd*kd) = (0.5*15.76%)+(0.5*7.56%) = 11.66%

Distribution division cost of equity (ke) = risk-free rate + beta*market risk premium = 7.6% + (1.2*4.8%) = 13.36%

Cost of capital for the manufacturing division = (we*ke) + (wd*kd) = (0.5*13.36%)+(0.5*7.56%) = 10.46%

b). The distribution division project should be taken up since its cost of capital is lower so for project with the same IRR of 16%, the profit will be more.