Problem
(Divisional costs of capital and investment decisions) In May of this year, Newcastle Mig. Comparry'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 capnal to approximately 12 percent. In the past, Newcastle has used a single firm-wide cost of capital to evaluate new investment.
However, managers have long recognized that the manufacturing division is significantly more rely than the distribution division. In fact, comparable firms in the manufacturing division have equity being of about 1 6, whereas distribution companies typically have equity betas of only 1. 1. Given the size of the two proposals, Newcastle's management tools it can undertake only con, 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:
1. The cost of debt financing in 7 percent before a marginal tax rate of 21 percent. You may assume this cost of debt is after any flotation costs the firm might incur.
2. The risk-from rate of interest on long-term U.S. Treasury bonds is currently 6.4 percent, and the market-risk premium has averaged 3.8 percent over the past several yours.
3. Both divisions adhere to target dabt ratios of 70 percent.
4. The firm has sufficient internally generated funds such that no now stock will have to be sold to rise equity financing
Task
1. Estimate the divisional costs of capital for the manufacturing and distribution divisions,
2. Which of the two projects should the firm undertake (assuming it cannot do both due to labor and other nonfinancial restraints)? Discuss.