Dimitrova Inc. is a Lawrence, Kansas-based health care holding company. In the past the firm’s managers...

Dimitrova Inc. is a Lawrence, Kansas-based health care holding company. In the past the firm’s managers have used the firm's cost of capital of 14.4 percent as the discount rate to evaluate all capital spending proposals. However, the firm has long recognized that its oxidation equipment division is significantly less risky than the biotechnology innovation division. Based on an analysis of comparable firms in the oxidation equipment and biotech innovation business along with their capital structures and tax rates, Dimitrova’s managers have decided to assign equity betas to the oxidation equipment division of 1.8, and 2.3 to the biotech innovation division. Given the importance of getting the best possible discount rate to use in project analysis, the firm's CFO has asked you to prepare cost of capital estimates for each of the two divisions.

The requisite information to accomplish your task is presented below:

(i) The company’s cost of debt financing is 8.2 percent before taxes of 25 percent. However, the before-tax cost of debt assigned to the oxidation equipment division is 7.5 percent, and 11.9 percent for the biotech innovation division. These debt costs are after any flotation costs the firm would incur. Both divisions face the same tax rate as the firm overall.

(ii) Assume the risk-free rate of interest on U.S. Treasury bonds is currently 1.4 percent and the market risk premium is anticipated to be 8.5 percent.

(iii) The oxidation equipment division funds 40 percent of its capital projects with debt, whereas the biotech innovation division utilizes 25 percent borrowed funds.

(iv) The firm has sufficient internally-generated funds so that no new stock will have to be sold to raise equity financing. a. Estimate the divisional costs of capital for the oxidation equipment and biotech innovation divisions.

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