(Divisional costs of capital and invostment 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 a return on invested capital to approximately 15 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 1.1. 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: • 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. • The risk-free rate of interest on long-term U.S. Treasury bonds is currently 7.3 percent, and the market-risk premium has averaged 4.7 percent over the past several years. • Both divisions adhere to target debt ratios of 50 percent. ..... a. What is the divisional cost of capital for the manufacturing division?
(Divisional costs of capital and invostment 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 a return on invested capital to approximately 15 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 1.1. 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: • 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. • The risk-free rate of interest on long-term U.S. Treasury bonds is currently 7.3 percent, and the market-risk premium has averaged 4.7 percent over the past several years. • Both divisions adhere to target debt ratios of 50 percent. ..... a. What is the divisional cost of capital for the manufacturing division?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:(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 a return on invested capital to approximately 15 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 1.1. 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:
• 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.
• The risk-free rate of interest on long-term U.S. Treasury bonds is currently 7.3 percent, and the market-risk premium has averaged 4.7 percent over the past
several years.
• Both divisions adhere to target debt ratios of 50 percent.
a. What is the divisional cost of capital for the manufacturing division?
D% (Round to two decimal places.)
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