Suppose your firm wanted to expand into a new line of business quickly through a

Question

Suppose your firm wanted to expand into a new line of business quickly through an existing division of the firm, and that management anticipated that the new line of business would constitute over 80 percent of your firm’s operations within three years. If the expansion was going to be financed partially with debt, would it still make sense to use the firm’s existing cost of debt, or should you compute a new rate of return for debt based on the new line of business? Explain why the divisional cost of capital approach may cause problems if the development of this line of business was assigned to the wrong division within the firm.

Explanation / Answer

Since the firm has decided to ventuire into a new line of business, the form should make sure that the new capital is utilised entirely for the new business.

Also, in that process, the cost of capital of the new line of business should be assessed as a separate entity from the existing line of business. Because, the existing business is at a maturity stage and as a consequence should have a lower cost of capital. But the new line of business is expected to grow at a faster rate which also indicates higher propensity of risk and as such should have a higher cost of capital or cost of debt in this case.

Also, the risk is further accentuated by the fact that 80% of the firm's business is expected to be from the new line of business in three years. In case, the new business fails to generate adequate cashflow, the whole firm would face the risk of insolvency.

Therefore, the firm should compute a new rate of return for debt on the new line of business.

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