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 a return on invested capital to approximately 14 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 1.6​, 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 11 percent before a marginal tax rate of 26 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 6.2 ​percent, and the​ market-risk premium has averaged 4.9 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

a. For calculating the cost of capital , we will be using the Capital Asset Pricing Model (CAPM).

Manufacturing division

Equity Beta = 1.6

Risk-free rate = 6.2%

Market Risk premium = 4.9%

Debt ratio ( D/V) = 70%

Equity ratio = 30%

Cost of Equity = 1.6*(4.9%) + 6.2% = 14.04%

Pre-tax Cost of debt = 11%

After-tax cost of debt = 11%*(1-26%) = 8.14%

Cost of capital = 14.04%*30% + 8.14%*70% = 9.91%

Distribution Division

The only change in assumptions is Beta = 1.2 which implies a lower cost of equity and in turn the cost of capital

Cost of Equity = 1.2*(4.9%) + 6.2% = 12.08%

Cos of capital = 12.08%*30% + 8.14%*70% = 9.32%

b.

Considering the management as an investor and the two divisions as separate companies, the cost of capital will be the rate of return on their investment for the management.

We can see from calculations in a. that Manufacturing division has higher cost of capital or rate of return.

Therefore, the firm should undertake the Manufacturing proposal as it generates higher return on capital.