(Divisional costs of capital and investment decisions) In May of thisyear, Newcastle Mfg.Company's capital investment review committee received two major investment proposals. One of the proposals was put forth by thefirm's domestic manufacturingdivision, and the other came from thefirm's distribution company. Both proposals promise a return on invested capital to approximately 13 percent. In thepast, Newcastle has used a singlefirm-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. Infact, 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 twoproposals, Newcastle's management feels it can undertake onlyone, 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 aspossible, thefirm'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 taskfollows:

The cost of debt financing is 9 percent before a marginal tax rate of 22 percent. You may assume this cost of debt is after any flotation costs the firm might incur.

Therisk-free rate of interest onlong-term U.S. Treasury bonds is currently 6.2 percent, and themarket-risk premium has averaged 4.5 percent over the past several years.

Both divisions adhere to target debt ratios of 60 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 nonfinancialrestraints)? Discuss.

a. What is the divisional cost of capital for the manufacturingdivision?

nothing

% (Round to two decimalplaces.)

What is the divisional cost of capital for the distributiondivision?

nothing

% (Round to two decimalplaces.)

b. Which of the two projects should the firm undertake(assuming it cannot do both due to labor and other non financialrestraints)?(Select the best choicebelow.)

A.

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

B.

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

C.

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

D.

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

(Growth rate in stock dividends and the cost of equity) In March of this pastyear, Manchester Electric(an electrical supply company operating throughout the southeastern United States and a publicly heldcompany) was evaluating the cost of equity capital for the firm. Thefirm's shares are selling for $49.12 ashare; it expects to pay an annual cash dividend of $4.86 a share nextyear, and thefirm's investors anticipate an annual rate of return of 12%.

a. If the firm is expected to provide a constant annual rate of growth individends, what rate of growth must the firmexperience?

b. If therisk-free rate of interest is 5% and the market risk premium is 6%, what must thefirm's beta be to warrant an expected rate of return 12% on thefirm's stock?

c. The discounted cash flow method for evaluating afirm's cost of equity financing is based on the assumption that future dividends grow at a constant rate forever. How do you think the cost of equity would be affected if the rate of growth in future dividends were to decline over time.

a. The constant annual rate of growth in dividends is

nothing

%. (Round to two decimalplaces.)

b. Thefirm's beta is

nothing

. (Round to one decimalplace.)

c. The cost of equity would

if the expected growth rate of dividends were to decline.(Select from thedrop-down menu.)