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 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 1.7whereas 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 8 percent before a marginal tax rate of 25 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 7.8 ​percent, and the​ market-risk premium has averaged 4.5 percent over the past several years.

Both divisions adhere to target debt ratios of 30 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.

a. What is the divisional cost of capital for the manufacturing​ division?

Answer 1

a]

Manufacturing​ division

cost of capital = (weight of debt * after tax cost of debt) + (weight of equity * cost of equity)

weight of debt = debt ratio = 30%

weight of equity = 1 - debt ratio = 1 - 30% = 70%

after tax cost of debt =  before tax cost of debt * (1 - tax rate)

after tax cost of debt =  8% * (1 - 25%) = 6%

cost of equity = risk free rate + (beta * market risk premium)

cost of equity = 7.8% + (1.7 * 4.5%)

cost of equity = 15.45%

cost of capital = (30% * 6%) + (70% * 15.45%)

cost of capital = 12.615%

Distribution​ division

cost of capital = (weight of debt * after tax cost of debt) + (weight of equity * cost of equity)

weight of debt = debt ratio = 30%

weight of equity = 1 - debt ratio = 1 - 30% = 70%

after tax cost of debt =  before tax cost of debt * (1 - tax rate)

after tax cost of debt =  8% * (1 - 25%) = 6%

cost of equity = risk free rate + (beta * market risk premium)

cost of equity = 7.8% + (1.1 * 4.5%)

cost of equity = 12.75%

cost of capital = (30% * 6%) + (70% * 15.45%)

cost of capital = 10.725%

b]

The expected return of the proposal is 15%.

The expected return is higher than the cost of capital of both divisions.

Therefore, the proposal with the lower cost of capital should be undertaken so that the value is maximized.

The distribution proposal should be undertaken