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 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: bullet The cost of debt financing is 8 percent before taxes of 35 percent. You may assume this cost of debt is after any flotation costs the firm might incur. bullet The​ risk-free rate of interest on​ long-term U.S. Treasury bonds is currently 5.9 ​percent, and the​ market-risk premium has averaged 4.9 percent over the past several years. bullet Both divisions adhere to target debt ratios of 40 percent. bullet The firm has sufficient internally generated funds such that no new stock will have to be sold to raise equity financing.

a. What is the divisional cost of capital for the manufacturing​ division? ____% ​(Round to two decimal​ places.)

What is the divisional cost of capital for the distribution​ division? ______​% ​(Round to two decimal​ places.)

b. Which of the two projects should the firm undertake​ (assuming it cannot do both due to labor and other non financial​ restraints)?  ​(Select the best choice​ below.)

A. Either project because their internal rates of return ​(IRR​) are equal.

B. Manufacturing project because the cost of capital is higher and thus the​ project's net present value ​(NPV​) is higher.

C. Manufacturing project because its divisional cost of capital is higher than that of distribution division.

D. Distribution project because the cost of capital is lower and thus the​ project's net present value ​(NPV​) is higher.

Answer 1