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Case Study: NewCastle Limited - Cost of Capital

View Solution # 27147

Price: $5.00

Newcastle Ltd is all-equity financed and has a cost of capital of 15 percent. A consultant suggests that Newcastle could easily borrow up to 50% of the value of its assets at an interest rate of 10% and achieve a rating for its debt of A+ or better. He argues that raising new capital by borrowing would lower the company’s cost of capital, and increase the NPV of some projects that were recently rejected. Use a numerical example to illustrate the consultant’s argument. Is his argument correct? Explain and justify your answer.

Solution

The Company's cost of capital is computed for the new structure. Using this value, an illustration is presented for an investment of 350,000 which will generate a cash flow of 100,000 per year for the next 5 years. A discussion on the argument is also included.

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