(Divisional costs of capital and investment decisions?) Belton Oil and Gas Inc. is a? Houston-based independent oil and gas firm. In the past? Belton's managers have used a single firmwide cost of capital of 10 percent to evaluate new investments. ? However, the firm has long recognized that its exploration and production division is significantly more risky than the pipeline and transportation division. In? fact, comparable firms to? Belton's E&P division have equity betas of about 1.6 ?, whereas distribution companies typically have equity betas of only 0.7 . 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 contained? here:
The cost of debt financing is 8 percent before taxes of 33 percent. ? However, if the? E&P division were to borrow based on its projects? alone, the cost of debt would probably be 9.8 ?percent, and the pipeline division could borrow at 6.2 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 U.S. Treasury bonds is currently 4.3 ?percent, and the? market-risk premium has averaged 6.6 percent over the past several years.
The? E&P division adheres to a target debt ratio of 40 ?percent, whereas the pipeline division utilizes 70 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. What is the divisional cost of capital for the? E&P division?
b. What is the divisional cost of capital for the pipeline? division?