(Divisional costs of capital and investment decisions) In May of this year, Newcastle Mfg. Company's capital investment review committee received two majo. 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 retu 12 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 betas 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 feel: 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 fir 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 21 percent. You may assume this cost of debt is after any flotation costs the firm might in - The risk-free rate of interest on long-term U.S. Treasury bonds is currently 4.8 percent, and the market-risk premium has averaged 7.3 percent over the past : - Both divisions adhere to target debt ratios of 40 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. 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 12 percent. In the past, Newcastle has used a single firing division, and the other came from the firm's distribution company. Both proposals promise a retum on invested capital to approximately However, managers have long recognized that the manufacturing of capital to evaluate new investments. betas of about 1.6, whereas distribution companies typically have equity betis significantly more risky than the distribution division. In fact, comparable firms in the manufacturing division have equity to be sure that it is taking on the more promising investment. Given the impotas of only 1.1. Given the size of the two proposals, Newcastle's management feels it can undertake only one, so it wants to prepare cost of capital estimates for each of the two divisions. The requisite information needed to accomital estimate as close to correct as possible, the firm's chief financial officer has asked you - The risk-free rate of interest on long-term U.S. Treasury bonds of 21 percent. You may assume this cost of debt is after any flotation costs the firm might incur. - Both divisions adhere to target debt ratios of 40 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
