EBK FOUNDATIONS OF FINANCE
10th Edition
ISBN: 9780135160473
Author: KEOWN
Publisher: PEARSON CO
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Chapter 9, Problem 20SP
(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 issued by the firm’s domestic manufacturing division, and the other came from the firm’s distribution company. Both proposals promise a
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 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 incur.
- 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 several years.
- 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.
- b. Which of the two projects should the firm undertake (assuming it cannot do both due to labor and other nonfinancial restraints)? Discuss.
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Mace Manufacturing is in the process of analyzing its investment decision-making procedures. Two projects evaluated by the firm recently involved building new facilities in different regions, North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table: ( see attached file)
d. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table.
e. If both analysts had used the weighted average cost calculated in part d, what recommendations would they have made regarding the North and South facilities?
f. Compare and contrast the analysts' initial recommendations with your findings in part e.Which decision method seems more appropriate? Explain why.
(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…
As a recent graduate of the UWIOC, The General Manager of the company has hired you to work alongside the Financial Controller of the company to help determine whether the company should invest in the new product line. He has provided you with the following questions to guide you in your assessment of the project and to present your findings to the Company.
1. Determine the weighted average cost of capital (WACC) for Vigour Pharmaceuticals. (Formula to be used is attached)
Chapter 9 Solutions
EBK FOUNDATIONS OF FINANCE
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