In June of this year, the Barramundi 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 return on invested capital equal to approximately 14 percent. In the past, Barramundi has used a single firm-wide cost of capital to evaluate new investments.

However, managers have long recognized that the manufacturing division is significantly riskier than the distribution division. In fact, compatible firms in the manufacturing division have equity betas of 1.7, whereas distribution companies typically have betas of only 1.2. Given the size of the two proposals, Barramundi’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 7 percent before a marginal tax rate of 23 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 Australian Treasury bonds is currently 4.9 percent, and the market-risk premium has average 7.4 percent over the past several years.

Both divisions adhere to target debt ratios of 45 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.