25. Sensitivity of Foreign Project Risk to Capital Structure. Texas Co. produces drugs and plans to acquire
a subsidiary in Poland. This subsidiary is a lab that would perform biotech research. Texas Co. is attracted
to the lab because of the cheap wages of scientists in Poland. The parent of Texas Co. would review the
lab research findings of the subsidiary in Poland when deciding which drugs to produce, and would then
produce the drugs in the U.S. The expenses incurred in Poland will represent about half of the total
expenses incurred by Texas Co. All drugs produced by Texas Co. are sold in the U.S. and this situation
would not change in the future. Texas Co. has considered 3 ways to finance the acquisition of the Polish
subsidiary if it buys it. First, it could use 50% equity funding (in dollars) from the parent and 50%
borrowed funds in dollars. Second, it could use 50% equity funding (in dollars) from the parent and 50%
borrowed funds in Polish zloty. Third, it could use 50% equity funding by selling new stock to Polish
investors denominated in Polish zloty and 50% borrowed funds denominated in Polish zloty. Assuming
that Texas Co. decides to acquire the Polish subsidiary, which financing method for the Polish subsidiary
would minimize the exposure of Texas to exchange rate risk? Explain.
ANSWER:Since all revenue is generated in dollars, Texas Co. should obtain all financing (debt and
26. Cost of Capital and Risk of Foreign Financing. Nevada Co. is a U.S. firm that conducts major
importing and exporting business in Japan, and all transactions are invoiced in dollars. It obtained debt in
the U.S. at an interest rate of 10 percent per year. The long-term risk-free rate in the U.S. is 8 percent. The
stock market return in the U.S. is expected to be 14 percent annually. Nevada’s beta is 1.2. Its target
capital structure is 30 percent debt and 70 percent equity. Nevada Co. is subject to a 25% corporate tax
rate.
a. Estimate the cost of capital to Nevada Co.
b. Nevada has no subsidiaries in foreign countries but plans to replace some of its dollar-denominated
debt with Japanese yen-denominated debt, since Japanese interest rates are low. It will obtain
yen-denominated debt at an interest rate of 5 percent. It can not effectively hedge the exchange rate
risk resulting from this debt because of parity conditions that makes the price of derivatives contracts
reflect the interest rate differential. How could Nevada Co. reduce its exposure to the exchange rate
risk resulting from the yen-denominated debt without moving its operations?
ANSWER:
a. Cost of debt = 10% x (1 – .25%) = 7.5%
27. Measuring the Cost of Capital. Messan Co. (a U.S. firm) borrows U.S. funds at an interest rate of 10
percent per year. Its beta is 1.0. The long-term annualized risk-free rate in the U.S. is 6 percent. The stock
market return in the U.S. is expected to be 16 percent annually. Messan’s target capital structure is 40
percent debt and 60 percent equity. Messan Co. is subject to a 30% corporate tax rate. Estimate the cost of
capital to Messan Co.
ANSWER:
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Multinational Cost of Capital and Capital Structure 2
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28. MNC’s Cost of Capital. Newark Co. is based in the U.S. About 30% of its sales are from exports to
Portugal. Newark Co. has no other international business. It finances its operations with 40% equity and
the remainder of funds with dollar-denominated debt. It borrows its funds from a U.S. bank at an interest
rate of 9 percent per year. The long-term risk-free rate in the U.S. is 6 percent. The long-term risk-free
rate in Portugal is 11 percent. The stock market return in the U.S. is expected to be 13 percent annually.
Newark’s stock price typically moves in the same direction and by the same degree as the U.S. stock
market. Its earnings are subject to a 20% corporate tax rate.
Estimate the cost of capital to Newark Co.
ANSWER:
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Cost of equity =
%)6%13(0.1%6
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
29. MNC’s Cost of Capital. Slater Co. is a U.S.-based MNC that finances all operations with debt and
equity. It borrows U.S. funds at an interest rate of 11 percent per year. The long-term risk-free rate in the
U.S. is 7 percent. The stock market return in the U.S. is expected to be 15 percent annually. Slater’s beta
is 1.4. Its target capital structure is 20 percent debt and 80 percent equity. Slater Co. is subject to a 30%
corporate tax rate. Estimate the cost of capital to Slater Co.
ANSWER:
Cost of debt = 11%
30. Change in Cost of Capital. Assume that Naperville Co. will use equity to finance a project in
Switzerland, while Lombard Co. will rely on a dollar-denominated loan to finance a project in
Switzerland, and that Addison Co. will rely on a Swiss franc-denominated loan to finance a project in
Switzerland. The firms will arrange their financing in one month. This week, the U.S. risk-free long-term
interest rate declined, but interest rates in Switzerland did not change. Do you think the estimated cost of
capital for the projects by each of these 3 U.S. firms increased, decreased, or remained unchanged ?
Explain.
ANSWER: The cost of U.S. debt and the cost of U.S. equity should decrease because they are influenced
31. Cost of Equity. Illinois Co. is a U.S. firm that plans to expand its business overseas. It plans to use all
equity to be obtained in the U.S. to finance a new project. The project’s cash flows are not affected by
U.S. interest rates. Just before Illinois Co. obtains new equity, the risk-free interest rate in the U.S. rises.
Will the change in interest rates increase, decrease, or have no effect on the required rate of return on the
project. Briefly explain.
ANSWER: An all-equity capital structure will allow the parent to have a higher cost of capital and a
32. Debt Financing Decision. Marks Co. (a U.S. firm) considers a project in which it will establish a
subsidiary in Zinland, and it expects that the subsidiary will generate large earnings in zin (the currency).
However, it is the Zinland government’s policy to block all funds so that earnings cannot be remitted to
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Multinational Cost of Capital and Capital Structure 4
the U.S. parent for at least 10 years; furthermore, the blocked funds cannot earn interest. The zin is
expected to weaken by 20% per year against the dollar over time. Marks Co. will borrow some funds to
finance the subsidiary. Should the company (a) obtain a dollar-denominated loan and convert the loan into
zin, or (b) obtain a zin-denominated loan, or (c) obtain half of the funds needed from each possible
source? [Assume that the interest rate from borrowing zin is the same as the interest rate from borrowing
dollars.] Briefly explain.
Solution to Continuing Case Problem: Blades, Inc.
1. If Blades expands into Thailand, do you think its cost of capital will be higher or lower than the cost
of capital of roller blade manufacturers operating solely in the United States? Substantiate your
answer by outlining how Blades’ characteristics distinguish it from domestic roller blade
manufacturers.
ANSWER: Blades’ cost of capital will probably be higher than the cost of capital of roller blade
manufacturers operating solely in the U.S. as a result of Blades’ expansion into Thailand. Usually, an
MNCs size, its access to international capital markets, and international diversification are favorable
2. According to the CAPM, how would Blades’ required rate of return be affected by an expansion into
Thailand? How do you reconcile this result with your answer to question 1? Do you think Blades
should use the required rate or return resulting from the CAPM to discount the cash flows of the Thai
subsidiary to determine its NPV?
ANSWER: Before Blades’ expansion into Thailand, its required rate of return according to the CAPM
was:
%19
%)5%12(2%5
)(
fmfe
RRBRk
Subsequent to Blades’ expansion into Thailand, its required rate of return according to the CAPM will
be:
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Multinational Cost of Capital and Capital Structure 5
%6.17
%)5%12(8.1%5
)(
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Thus, the required rate of return on equity would decrease by 1.4 percent as a result of Blades’
expansion into Thailand.
The answer to question 1 suggests that Blades’ cost of capital would increase as a result of its
Many MNCs consider unsystematic risk when assessing the risk of operating in a foreign country.
Since Blades is not currently operating in other countries besides the U.S. and Thailand, economic
3. If Blades borrows funds in Thailand to support its Thai subsidiary, how would this affect its cost of
capital? Why?
ANSWER: If Blades borrows funds in Thailand to support its Thai subsidiary, its cost of capital
4. Given the high level of interest rates in Thailand, the high level of exchange rate risk, and the high
(perceived) level of country risk, do you think Blades will be more or less likely to use debt in its
capital structure as a result of its expansion into Thailand? Why?
ANSWER: Given the high levels of interest rates, exchange rate risk, and (perceived) country risk in
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Multinational Cost of Capital and Capital Structure 6
Solution to Supplemental Case: Sabre Computer Corporation
a. The cost of financing is composed of a risk-free rate and a risk premium. The Mexican joint venture
b. While the Mexican venture will have higher financing costs, the Mexican subsidiary will not
Small Business Dilemma
Multinational Capital Structure Decision at the Sports Exports Company
1. What is an advantage of using equity to support the subsidiary? What is a disadvantage?
ANSWER: An advantage is that retained earnings may be a relatively low-cost method of financing.
A disadvantage of using equity is that it has to be converted into pounds to support the British
subsidiary. This creates a new form of exposure to the future value of the pound, which is similar to
the exposure that the firm would have reduced by producing the footballs in the United Kingdom.
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Multinational Cost of Capital and Capital Structure 7
2. If Jim decided to use long-term debt as its primary form of capital to support this subsidiary, should
he use dollar-denominated debt or pound-denominated debt?
ANSWER: Jim should use pound-denominated debt, because this creates a cash outflow on interest
3. How can the equity proportion of this firm’s capital structure increase over time after it is more
established?
ANSWER: It will generate earnings that can be retained and reinvested as an equity investment in
the firm.
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