Ebertlang Corporation is a provider of computer software and IT services in two of the largest regions of Eastern Europe. In the past, the company’s managers have used a single company-wide cost of capital of 12 percent to evaluate new investments. However, the firm has long recognized that its Division A (operating in Region 1) is significantly riskier than Division B (operating in Region 2).

In fact, companies comparable to Ebertlang’s Division A have equity betas of about 2.0, whereas companies comparable to Ebertlang’s Division B have equity betas of only about 0.5. 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 is presented here:

The cost of debt financing is 6 percent for Division A, while Division B could borrow at 11 percent. You may assume these costs of debt are after any flotation costs the firm might incur.

The risk-free rate of interest on long-term Treasury bonds is currently 4.5 percent, and the market-risk premium has averaged 6 percent over the past several years.

Division A adheres to a target debt ratio of 5 percent, whereas Division B utilizes 45 percent borrowed funds.

The firm has sufficient internally generated funds such that no new stock will have to be sold to raise equity financing.

a. Estimate the weighted average costs of capital for both the divisions.

b. How acceptable is the investment at 12 percent?

What are the implications of using a company-wide cost of capital to evaluate new investment proposals in light of the differences in the costs of capital you estimated previously?