978-0134472133 Excel Chapter 13

a. What is Electrolux’s cost of debt, after-tax, in SEK?

b. What is Electrolux’s cost of equity in SEK?

c. What is the Electrolux’s market capitalization?

d. What is Electrolux’s total value of equity outstanding?

e. What proportion of Electrolux’s capital structure is debt?

f. What proportion of Electrolux’s capital structure is equity?

g. What is Electrolux’s weighted average cost of capital?

Assumptions Values

Swedish kroner, government bond rate (10-year) 4.30%

Electrolux credit risk premium 1.20%

Swedish corporate tax rate 26.00%

Electrolux beta 1.30

Swedish equity market risk premium (equity return over risk-free) 4.00%

ke = krf + ( km – krf ) β

d. Electrolux’s total value of equity outstanding SEK 52,075,660,000

Share price x shares outstanding

Problem 13.1 Electrolux of Sweden’s Cost of Capital

Kristian Thalen has just joined the corporate treasury group at Electrolux of Sweden, the multinational

Swedish appliance maker. Electrolux is considering making an offer for GE’s appliance business, and wants

to revise its weighted average cost of capital for its analysis in its home currency, the Swedish kroner (SEK).

Kristian has been assigned the task. Using the following assumptions, he goes step by step through the

following questions.

a. What is Ferrari’s cost of debt, after-tax, in euros?

b. What is Ferrari’s cost of equity in euros?

c. What is Ferrari’s market capitalization?

d. What is Ferrari’s total value of equity outstanding?

e. What proportion of Ferrari’s capital structure is debt?

f. What proportion of Ferrari’s capital structure is equity?

g. What is Ferrari’s weighted average cost of capital?

h. What is Ferrari’s WACC if its beta was higher, like other automotive companies, say 1.20?

Assumptions Values

Italian risk-free cost of debt in euros (€)4.00%

Ferrari’s cost of debt in euros (€)3.99%

Italian corporate income tax rate 33.50%

Ferrari’s prospective beta 0.90

Italian equity market risk premium (equity return over risk-free) 5.50%

Ferrari’s shares outstanding 189,000,000

Ferrari’s share price in euros € 48.00

Ferrari’s debt outstanding in euros € 510,000,000

a. Ferrari’s cost of debt, after-tax, in euros 2.653%

kd = ( krf + credit risk premium ) x ( 1 – tax rate )

b. Ferrari’s cost of equity in euros 8.940%

ke = krf + ( km – krf ) β

c. Ferrari’s market capitalization € 9,072,000,000

Share price x shares outstanding

d. Ferrari’s total value of equity outstanding € 9,072,000,000

Share price x shares outstanding

e. What proportion of Ferrari’s capital structue is debt? 5.32%

Debt / ( Debt + Equity )

f. What proportion of Ferrari’s capital structure is equity? 94.68%

Equity / ( Debt + Equity )

g. What is Ferrari’s weighted average cost of capital? 8.61%

Problem 13.2 Ferrari’s IPO & WACC

Ferrari, the famous high-performance automotive group, launched its initial public offering (IPO) on October 20, 2015.

Although the share price had initially risen to over 57 per share, by the end of the year it had settled to 48. Ferrari had

been owned by Fiat (Italy), and had never calculated its own cost of capital before, one independent of Fiat. It now

needed to, and one of its first challenges was estimating its beta. With only two months of trading to base it on, the

corporate treasury group had started with what were considered ‘comparable firms’, which for Ferrari, meant firms in the

luxury goods industry, not automotive. Luxury goods were historically less volatile than the market, so the initial guess

on Ferrari’s beta was 0.90. Using the following assumptions, answer the questions.

You might notice that Ferrari’s cost of debt is actually cheaper than that of the Italian government. This was true, and

reflected Ferrari’s greater-than-Italy reach for its financial security, while also reflecting Italy’s continuing challenge

with sovereign debt.

WACC = ( kd (1-tax) * D/(D+E)) + ( ke * E/(D+E))

g. What is Ferrari’s WACC if bet is higher, say 1.20? 10.17%

Replacing the beta value above, and using the calculations that follow.

It will be interesting to see over time whether Ferrari’s beta will emulate that of a

luxury good or an automotive company.

a. Ganado’s cost of equity

b. Ganado’s cost of debt

c. Ganado’s weighted average cost of capital

Domestic International

Assumptions CAPM ICAPM

Ganado’s beta, β1.05 0.85

Risk-free rate of interest, krf 3.60% 3.60%

Company credit risk premium 4.40% 4.40%

Cost of debt, before tax, kd 8.00% 8.00%

Corporate income tax rate, t 35% 35%

General return on market portfolio, km 9.00% 8.00%

Optimal capital structure:

Proportion of debt, D/V 30% 30%

Proportion of equity, E/V 70% 70%

a) Ganado’s cost of equity 9.270% 7.340%

ke = krf + ( km – krf ) β

b) Ganado’s cost of debt, after tax 5.200% 5.200%

kd x ( 1 – t )

c) Ganado’s weighted average cost of capital 8.049% 6.6980%

WACC = [ ke x E/V ] + [ ( kd x ( 1 – t ) ) x D/V ]

Problem 13.3 Ganado’s Cost of Capital

Maria Gonzalez now estimates the risk-free rate to be 3.60%, the company‘s credit risk premium is 4.40%, the

domestic beta is estimated at 1.05, the international beta estimated at .85, and the company‘s capital structure is

now 30% debt. All other values remain the same as those presented in this chapter in the section “Sample

Calculation: Ganado’s Cost of Capital.”. For both the domestic CAPM and ICAPM, calculate the following:

a. 8.00% c. 5.00%

b. 7.00% d. 4.00%

Domestic International

Assumptions CAPM ICAPM

Ganado’s beta, β1.05 0.85

Risk-free rate of interest, krf 4.00% 4.00%

Company credit risk premium 4.40% 4.40%

Cost of debt, before tax, kd 8.40% 8.40%

Corporate income tax rate, t 35% 35%

Equity risk premium 8.00% 8.00%

General return on market portfolio, km 12.00% 12.00%

Optimal capital structure:

Proportion of debt, D/V 30% 30%

Proportion of equity, E/V 70% 70%

a) Ganado’s cost of equity 12.400% 10.800%

ke = krf + ( km – krf ) β

b) Ganado’s cost of debt, after tax 5.460% 5.460%

kd x ( 1 – t )

c) Ganado’s weighted average cost of capital 10.318% 9.198%

WACC = [ ke x E/V ] + [ ( kd x ( 1 – t ) ) x D/V ]

Differing Equity Risk Premiums CAPM ICAPM

a. 8.00% 10.318% 9.198%

b. 7.00% 9.583% 8.603%

c. 5.00% 8.113% 7.413%

d. 4.00% 7.378% 6.818%

Problem 13.4 Ganado and Equity Risk Premiums

Using the original weighted average cost of capital data for Ganado used in the chapter in the section, “Sample

Calculation:Ganado’s Cst of Capital,” calculate both the CAPM and ICAPM costs of capital for the following

equity risk premium estimates.

Answer for part a

a. If Thunderhorse beta is estimated at 1.1, what is its weighted average cost of capital?

Assumptions a) Values b) Values

Thunderhorse’s beta 1.10 0.80

Cost of debt, before tax 7.000% 7.000%

Risk-free rate of interest 3.000% 3.000%

Corporate income tax rate 25.000% 25.000%

General return on market portfolio 8.000% 8.000%

Optimal capital structure:

Proportion of debt, D/V 60% 60%

Proportion of equity, E/V 40% 40%

Calculation of the WACC

Cost of debt, after-tax 5.250% 5.250%

kd x ( 1 – t )

Cost of equity, after-tax 8.500% 7.000%

ke = krf + ( km – krf ) β

WACC 6.550% 5.950%

WACC = [ ke x E/V ] + [ ( kd x ( 1 – t ) ) x D/V ]

Problem 13.5 Thunderhose Oil

b. If Thunderhorse’s beta is estimated at 0.8, significantly lower because of the continuing profit

prospects in the global energy sector, what is the company‘s weighted average cost of capital?

Thunderhorse Oil is a U.S. oil company. Its current cost of debt is 7%, and the 10-year U.S. Treasury

yield, the proxy for the risk-free rate of interest, is 3%. The expected return on the market portfolio is

8%. The company‘s effective tax rate is 39%. Its optimal capital structure is 60% debt and 40% equity.

a. What is Nestle’s cost of equity based on the domestic portfolio of a Swiss investor?

b. What is Nestle’s cost of equity based on a global portfolio for a Swiss investor?

Assumptions Domestic Portfolio Global Portfolio

Swiss bond index yield, the risk-free rate 0.520% 0.520%

Swiss equity market return, in Swiss francs 8.400%

Global equity yield, in Swiss francs 8.820%

Nestle’s beta versus Swiss equity market 0.825

Nestle’s beta versus Global equity market 0.515

Nestle’s cost of equity using CAPM 7.0210% 4.7945%

Problem 13.6 Nestle of Switzerland Revisited

Nestle of Switzerland is revisiting its cost of equity analysis. As a result of extraordinary actions by the

Swiss Central Bank, the Swiss bond index yield (10-year maturity) has dropped to a record low of

0.520%. The Swiss equity markets have been averaging 8.400% returns, while the Financial Times

global equity market returns, indexed back to Swiss francs, is at 8.820%. Nestle’s corporate treasury staff

has estimated the company’s domestic beta at 0.825, but its global beta (against the larger global equity

market portfolio) at .515.

a. If Corcovado’s beta is estimated at 1.1, what is its weighted average cost of capital?

Assumptions a. Values b. Values

Corcovado’s beta 1.10 0.80

Cost of debt, before tax 7.000% 7.000%

Risk-free rate of interest 3.000% 3.000%

Corporate income tax rate 25.000% 25.000%

General return on market portfolio 8.000% 8.000%

Optimal capital structure:

Proportion of debt, D/V 60% 60%

Proportion of equity, E/V 40% 40%

Calculation of the WACC

Cost of debt, after-tax 5.250% 5.250%

kd x ( 1 – t )

Cost of equity, after-tax 8.500% 7.000%

ke = krf + ( km – krf ) β

WACC 6.550% 5.950%

WACC = [ ke x E/V ] + [ ( kd x ( 1 – t ) ) x D/V ]

Problem 13.7 Corcovado Pharmaceuticals

Corcovado Pharmaceutical’s cost of debt is 7%. The risk-free rate of interest is 3%. The expected return

on the market portfolio is 8%. After effective taxes, Corcovado’s effective tax rate is 25%. Its optimal

capital structure is 60% debt and 40% equity.

b. If Corcovado’s beta is estimated at 0.8, significantly lower because of the continuing profit prospects

in the global energy sector, what is its weighted average cost of capital?

Assumptions Values

Combined federal and state tax rate 40%

Desired capital structure:

Proportion debt 50%

Proportion equity 50%

Capital to be raised 120,000,000$

Cost of Cost of Cost of Cost of

Domestic Domestic European European

Costs of Raising Capital in the Market Equity Debt Equity Debt

Up to $40 million of new capital 12% 8% 14% 6%

$41 million to $80 million of new capital 18% 12% 16% 10%

Above $80 million 22% 16% 24% 18%

Incremental

a. To raise $120,000,000 Debt Market Debt Cost Equity Market Equity Cost WACC

First $40,000,000 European 6.00% Domestic 12.00% 7.80%

Second $40,000,000 European 10.00% European 16.00% 11.00%

Third $40,000,000 Domestic 16.00% Domestic 22.00% 15.80%

Weighted average cost 10.67% 16.67% 11.53%

(equal weights) (equal weights)

Incremental

b. To raise $60,000,000 Debt Market Debt Cost Equity Market Equity Cost WACC

First $40,000,000 European 6.00% Domestic 12.00% 7.80%

Additional $20,000,000 European 10.00% European 16.00% 11.00%

Weighted average cost 7.33% 13.33% 8.87%

(2/3 & 1/3 weights) (2/3 & 1/3 weights)

Problem 13.8 WestGas Conveyance, Inc.

A London bank advises WestGas that U.S. dollars could be raised in Europe at the following costs, also in multiples of $20 million, while maintaining

the 50/50 capital structure.

b. If WestGas plans an expansion of only $60 million, how should that expansion be financed? What will be the weighted average cost of capital for

the expansion?

Each increment of cost would be influenced by the total amount of capital raised. That is, if WestGas first borrowed $20 million in the European

market at 6% and matched this with an additional $20 million of equity, additional debt beyond this amount would cost 12% in the United States and

10% in Europe. The same relationship holds for equity financing.

a. Calculate the lowest average cost of capital for each increment of $40 million of new capital, where WestGas raises $20 million in the equity

market and an additional $20 in the debt market at the same time.

WestGas Conveyance, Inc., is a large U.S. natural gas pipeline company that wants to raise $120 million to finance expansion. WestGas wants a

capital structure that is 50% debt and 50% equity. Its corporate combined federal and state income tax rate is 40%. WestGas finds that it can finance in

the domestic U.S. capital market at the rates listed below. Both debt and equity would have to be sold in multiples of $20 million, and these cost

figures show the component costs of debt and equity, if raised half by equity and half by debt.

Assumptions Symbol Goldman Sachs Bank of New York

Components of beta: β

Estimate of correlation between security and market ρjm 0.90 0.85

Estimate of standard deviation of Kashmiri’s returns σj 24.0% 30.0%

Estimate of standard deviation of market’s return σm18.0% 22.0%

Risk-free rate of interest krf 3.0% 3.0%

Estimate of Kashmiri’s cost of debt in US market kd 7.5% 7.8%

Estimate of market return, forward-looking km 9.0% 12.0%

Corporate tax rate t 35.0% 35.0%

Proportion of debt D/V 35% 40%

Proportion of equity E/V 65% 60%

Estimating Costs of Capital

Estimated beta

β = ( ρjm x σj ) / ( σm ) β1.20 1.16

Estimated cost of equity

ke = krf + (km – krf) βke 10.200% 13.432%

Estimated cost of debt

kd ( 1 – t ) kd (1-t) 4.875% 5.070%

Estimated weighted average cost of capital

WACC = (ke x E/V) + ( (kd x (1-t)) x D/V) WACC 8.336% 10.087%

Problem 13.9 Kashmiri’s Cost of Capital

Kashmiri is the largest and most successful specialty goods company based in Bangalore, India. It has not yet entered the

North American marketplace, but is considering establishing both manufacturing and distribution facilities in the United

States through a wholly owned subsidiary. It has approached two different investment banking advisors, Goldman Sachs and

Bank of New York, for estimates of what its costs of capital would be several years into the future when it planned to list its

American subsidiary on a U.S. stock exchange. Using the following assumptions by the two different advisors, calculate the

prospective costs of debt, equity, and the WACC for Kashmiri (U.S.),

Assumptions Symbol Company A Company B Cargill

Total sales Sales $10.5 billion $45 billion $113 billion

Company’s beta β0.83 0.68 0.90

Company credit rating S&P AA AAA

Risk-free rate of interest krf 4.5% 4.5% 4.5%

Market risk premium km-krf 5.5% 5.5% 5.5%

Weighted average cost of debt kd 6.885% 7.125% 6.820%

Corporate tax rate t 48.0% 48.0% 48.0%

Debt to total capital ratio D/V 34% 41% 28%

Equity to total capital ratio E/V 66% 59% 72%

International sales as % of total sales 11% 34% 54%

Estimating Costs of Capital Symbol Company A Company B Cargill

Cost of equity

ke = krf + (km – krf) βke 9.065% 8.240% 9.450%

Cost of debt, after-tax kd ( 1 – t ) 3.580% 3.705% 3.546%

Weighted average cost of capital WACC 7.200% 6.381% 7.797%

WACC = (ke x E/V) + ( (kd x (1-t)) x D/V)

Once the data is organized, the absence of a beta for Cargill is the obvious data deficiency.

A series of observations is then helpful:

1. Note that beta and credit ratings do not necessarily parallel one another

2. Credit rating and cost of debt do follow expected norms; lower the rating, the higher the cost

3. Both comparable companies, in the same industry as Cargill (commodities), possess relatively low betas

4. Cargill’s sales are twice that of the next largest firm

5. Cargill’s sales are significantly more internationally diversified than either of the other two companies; the question

is whether this is a positive or negative factor for the estimation of Cargill’s cost of equity?

If we take the approach that the beta for Cargill has to pick up all the incremental information, the beta would then fall

between say 0.80 and 1.00. If the higher degree of international sales was interpreted as increasing risk, beta would

be on the higher end; yet being a commodity firm in the current market, its beta would rarely surpass 1.0. A value of

0.90 is shown here giving a WACC of 7.797%. A series of sensitivities would find a WACC between 7.1% and 7.9%.

Problem 13.10 Cargill’s Cost of Capital

Comparables

Cargill is generally considered to be the largest privately held company in the world. Headquartered in Minneapolis, Minnesota,

the company has been averaging sales of over $113 billion per year over the past 5 year period. Although the company does not

have publicly traded shares, it is still extremely important for it to calculate its weighted average cost of capital properly in

order to make rational decisions on new investment proposals.

Assuming a risk-free rate of 4.50%, an effective tax rate of 48%, and a market risk premium of 5.50%, estimate the weighted

average cost of capital first for companies A and B, and then make a ‘guestimate’ of what you believe a comparable WACC

would be for Cargill.

Brazilian Economic Performance 1995 1996 1997 1998 1999 Mean

Inflation rate (IPC) 23.20% 10.00% 4.80% 1.00% 10.50% 9.90%

Bank lending rate 53.10% 27.10% 24.70% 29.20% 30.70% 32.96%

Exchange rate (reais/$) 0.972 1.039 1.117 1.207 1.700 120.7%

Equity returns (Sao Paulo Bovespa) 16.0% 28.0% 30.2% 33.5% 151.9% 51.92%

All three are on the right track. It is mostly a matter of finding the linkages beween their individual arguments.

1. Theoretically, Curly is correct in that CAPM assumes that all equity returns are over and above risk-free rates. These are of course,

expected returns, and are the investor’s expectations or requirements going INTO the investment.

2. Mo is also correct in arguing that regardless of what investors may EXPECT, the results are often quite different, sometimes disappointing.

Theoretically, when the investment does not yield at least the expected return, the investor should indeed liquidate their position. However,

in reality, many investors for a variety of reasons (tax implications, investment horizon, etc.), may stay in the investment and just complain

about the past and hope about the future.

3. Larry also is on the right track arguing that actual market returns will often result in less than various interest or debt instruments. One of

the more helpful arguments here is that equity returns and interest returns arise from very different economic and financial processes. Most

interest rate charges are stated and contracted for up-front, and represent lenders’ perception of an adequate risk-adjusted return over the

expected rate of inflation for the coming period. Equity returns, however, are that mystical process of equity markets in which the many

different motives of equity investors combine to move markets in sometimes mysterious ways, independent of interest rates, inflation rates,

or any other fundamental money price.

Problem 13.11 The Tombs

At this point both Larry and Mo simply stared at Curly – pause – and both ordered another beer. Using the Brazilian data presented, comment on this

week’s debate at the Tombs.

Larry argues that “its all about expected versus delivered. You can talk about what equity investors expect, but they often find that what is delivered for

years at a time is so small – even sometimes negative – that in effect the cost of equity is cheaper than the cost of debt.”

Curly is the theoretician. “Ladies, this is not about empirical results; it is about the fundamental concept of risk-adjusted returns. An investor in equities

knows he will reap returns only after all compensation has been made to debt-providers. He is therefore always subject to a higher level of risk to his return

than debt instruments, and as the capital asset pricing model states, equity investors set their expected returns as a risk-adjusted factor over and above the

returns to risk-free instruments.”

Moe interrupts: “But you’re missing the point. The cost of capital is what the investor requires in compensation for the risk taken going into the

investment. If he doesn’t end up getting it, and that was happening here, then he pulls his capital out and walks.”

You have joined your friends at the local watering hole, The Tombs, for your weekly debate on international finance. The topic this week is whether the

cost of equity can ever be cheaper than the cost of debt. The group has chosen Brazil in the mid-1990s as the subject of the debate. One of the group

members has torn the following table of data out of a book, which is then the subject of the analysis.

Before After

Assumptions Symbol Diversification Diversification

Correlation between G-H and the market ρjm 0.88 0.76

Standard deviation of G-H‘s returns σj 28.0% 26.0%

Standard deviation of market’s returns σm18.0% 18.0%

Risk-free rate of interest krf 3.0% 3.0%

Additional equity risk premium for internationalization RPM 0.0% 3.0%

Estimate of G-H’s cost of debt in US market kd 7.2% 7.0%

Market risk premium km-krf 5.5% 5.5%

Corporate tax rate t 35.0% 35.0%

Proportion of debt D/V 38% 32%

Proportion of equity E/V 62% 68%

Estimating Costs of Capital

Estimated beta

β = ( ρjm x σj ) / ( σm ) β1.37 1.10

Estimated cost of equity

ke = krf + (km – krf) βke 10.529% 9.038%

Estimated cost of equity with additional risk premium

ke* = krf + (km – krf) β + RPM ke + RPM 10.529% 12.038%

This may be a case where everyone is correct. When G-H’s beta is recalculated, it falls in value as a result of

the reduced correlation of its returns with the home market (diversification benefit). This then creates a standard cost of

equity which is cheaper at 9.038% (previous cost of equity was 10.529%).

If, however, the market was to add an additional risk premium to the firm’s cost of equity as a result of internationally

diversifying operations, and if that risk premium were on the order of 3.0%, the final risk-adjusted cost of equity is

indeed higher, 12.038% to the before value of 10.529%.

Problem 13.12 Genedak-Hogan Cost of Equity

Use the following information to answer questions 10 through 12. Genedak-Hogan is an American conglomerate which is actively

debating the impacts of international diversification of its operations on its capital structure and cost of capital. The firm is

planning on reducing consolidated debt after diversification.

Senior management at Genedak-Hogan is actively debating the implications of diversification on its cost of equity. All agree that

the company’s returns will be less correlated with the reference market return in the future, the financial advisors believe that the

market will assess an additional 3.0% risk premium for ‘going international’ to the basic CAPM cost of equity. Calculate Genedak-

Hogan’s cost of equity before and after international diversification of its operations, with and without the hypothetical additional

risk premium, and comment on the discussion.

Calculate the weighted average cost of capital for Genedak-Hogan for before and after international diversification.

Before After

Assumptions Symbol Diversification Diversification

Correlation between G-H and the market ρjm 0.88 0.76

Standard deviation of G-H‘s returns σj 28.0% 26.0%

Standard deviation of market’s returns σm18.0% 18.0%

Risk-free rate of interest krf 3.0% 3.0%

Additional equity risk premium for internationalization RPM 0.0% 3.0%

Estimate of G-H’s cost of debt in US market kd 7.2% 7.0%

Market risk premium km-krf 5.5% 5.5%

Corporate tax rate t 35.0% 35.0%

Proportion of debt D/V 38% 32%

Proportion of equity E/V 62% 68%

Before After

Estimating Costs of Capital Diversification Diversification

Estimated beta

β = ( ρjm x σj ) / ( σm ) β1.37 1.10

Estimated cost of equity

ke = krf + (km – krf) βke 10.529% 9.038%

Estimated cost of equity with additional risk premium

ke* = krf + (km – krf) β + RPM ke + RPM 10.529% 12.038%

Cost of debt, after-tax kd (1-t)

kd ( 1 – t ) 4.680% 4.550%

Weighted average cost of capital WACC

WACC = (ke x E/V) + ( (kd x (1-t)) x D/V) 8.306% 7.602%

Weighted average cost of capital with RPM WACC*

WACC = (ke* x E/V) + ( (kd x (1-t)) x D/V) 8.306% 9.642%

There are a number of different factors at work here. First, as a result of international diversification, their access to debt

has improved, resulting in a lower cost of debt capital. This is not fully appreciated, however, as the firm has chosen to

reduce its overall use of debt post-diversification (common among MNEs).

The firm’s WACC does indeed drop for the standardized case. If, however, the market assesses an additional equity risk

premium of 3.0%, the benefits are swamped by the higher required return on equity by the market.

Problem 13.13 Genedak-Hogan’s WACC

a. Did the reduction in debt costs reduce the firm’s weighted average cost of capital? How would you describe the impact of

international diversification on its costs of capital?

b. Adding the hypothetical risk premium to the cost of equity introduced in problem 13.12 (an added 3.0% to the cost of equity

because of international diversification), what is the firm’s WACC?

Before After

Assumptions Symbol Diversification Diversification

Correlation between G-H and the market ρjm 0.88 0.76

Standard deviation of G-H‘s returns σj 28.0% 26.0%

Standard deviation of market’s returns σm18.0% 18.0%

Risk-free rate of interest krf 3.0% 3.0%

Additional equity risk premium for internationalization RPM 0.0% 3.0%

Estimate of G-H’s cost of debt in US market kd 7.2% 7.0%

Market risk premium km-krf 5.5% 5.5%

Corporate tax rate t 35.0% 32.0%

Proportion of debt D/V 38% 32%

Proportion of equity E/V 62% 68%

Before After

Estimating Costs of Capital Diversification Diversification

Estimated beta

β = ( ρjm x σj ) / ( σm ) β1.37 1.10

Estimated cost of equity

ke = krf + (km – krf) βke 10.529% 9.038%

Estimated cost of equity with additional risk premium

ke* = krf + (km – krf) β + RPM ke + RPM 10.529% 12.038%

Cost of debt, after-tax kd (1-t)

kd ( 1 – t ) 4.680% 4.760%

Weighted average cost of capital WACC

WACC = (ke x E/V) + ( (kd x (1-t)) x D/V) 8.306% 7.669%

Weighted average cost of capital with RPM WACC*

WACC = (ke* x E/V) + ( (kd x (1-t)) x D/V) 8.306% 9.709%

The reduction in the effective tax rate obviously impacts WACC through the cost of debt. This does have substantial

benefits in the company‘s WACC — as long as additional equity risk premiums are not assessed. Then, even the lower

effective tax rate does not offset the higher equity costs associated with the international risk premium.

Problem 13.14 Genedak-Hogan’s WACC and Effective Tax Rate

Many MNEs have greater ability to control and reduce their effective tax rates when expanding international operations. If

Genedak-Hogan was able to reduce its consolidated effective tax rate from 35% to 32%, what would be the impact on its WACC?