Answer of Chapter 4

Problem Set 4

International Finance

Shrikhande

Fall 2006

A. International Cost of Capital

1. A firm with a corporate-wide debt/equity ratio of 1:2, an after-tax cost of debt of 7%, and a cost of equity capital of 15% is interested in pursuing a foreign project. The debt capacity of the project is the same as for the company as a whole, but its systematic risk is such that the required return on equity is estimated to be about 12%. The after-tax cost of debt is expected to remain at 7%.

a. What is the project's weighted average cost of capital? How does it compare with the parent's WACC?

Answer. The weighted average cost of capital for the project is

kI = (1 - w) x ke' + w x id(1 - t)

where w is the ratio of debt to total assets, ke' is the required risk-adjusted return on project equity, and id(1 - t) is the after-tax cost of debt for the project. Substituting in the numbers provided yields

kI = 2/3 x 12% + 1/3 x 7% = 10.33%

b. If the project's equity beta is 1.21, what is its unlevered beta?

Answer. The following approximation is usually used to unlever beta:

Unlevered beta = levered beta/[1 + (1 - t)D/E]

where t is the firm's marginal tax rate and D/E is its debt/equity ratio. Without knowing the firm's marginal tax rate, we cannot unlever beta. Assuming that the marginal tax rate is about 40%, the unlevered beta is

Unlevered beta = 1.21/[1 + (1 - .4)2] = .93

2. Suppose that a foreign project has a beta of 0.85, the risk-free return is 12%, and the required return on the market is estimated at 19%. What is the cost of capital for the project?

Answer. The cost of capital for the project is

k* = Rf + β*[E(Rm) - Rf]

where Rf is the risk-free required return, β* is the project beta, and E(Rm) is the expected return on the market. Substituting in the numbers provided in the problem yields

k* = .12 + .85(.19 - .12) = 17.95%

3. Compania Troquelados ARDA is a medium-sized Mexico City auto parts maker. It is trying to decide whether to borrow...