23. Financing with Foreign Equity. Orlando Co. has its U.S. business funded in dollars with a capital
structure of 60% debt and 40% equity. It has its Thailand business funded in Thai baht with a capital
structure of 50% debt and 50% equity. The corporate tax rate on U.S. earnings and on Thailand
earnings is 30%. The annualized 10-year risk-free interest rate is 6% in the U.S. and 21% in Thailand.
The annual real rate of interest is about 2% in the U.S. and in Thailand. Interest rate parity exists.
Orlando pays 3 percentage points above the risk-free rates when it borrows, so its before-tax cost of
debt is 9% in the U.S. and 24% in Thailand. Orlando expects that the U.S. annual stock market return
will be 10% per year, and the Thailand annual stock market return will be 28% per year. Its business
in the U.S. has a beta of .8 relative to the U.S. market, while its business in Thailand has a beta of 1.1
relative to the Thai market. The equity used to support Orlando’s Thai business was created from
retained earnings by the Thailand subsidiary in previous years. However, Orlando Co. is considering
a stock offering in Thailand that is denominated in Thai baht and targeted at Thai investors. Estimate
Orlando’s cost of equity in Thailand that would result from issuing stock in Thailand.
ANSWER:
Estimate cost of equity in Thailand
24. Assessing Foreign Project Funded With Debt and Equity. Nebraska Co. plans to pursue a project
in Argentina that will generate revenue of 10 million Argentine pesos (AP) at the end of each of the
next 4 years. It will have to pay operating expenses of AP3 million per year. The Argentine
government will charge a 30% tax rate on profits. All after-tax profits each year will be remitted to
the U.S. parent and no additional taxes are owed. The spot rate of the AP is presently $.20. The AP is
expected to depreciate by 10% each year for the next 4 years. The salvage value of the assets will be
worth AP40 million in 4 years after capital gains taxes are paid. The initial investment will require
$12 million, half of which will be in the form of equity from the U.S. parent, and half of which will
come from borrowed funds. Nebraska will borrow the funds in Argentine pesos. The annual interest
rate on the funds borrowed is 14%. Annual interest (and zero principal) is paid on the debt at the end
of each year, and the interest payments can be deducted before determining the tax owed to the
Argentine government. The entire principal of the loan will be paid at the end of year 4. Nebraska
requires a rate of return of at least 20% on its invested equity for this project to be worthwhile.
Determine the NPV of this project. Should Nebraska pursue the project?
ANSWER:
Initial investment of $12 million is supported by one-half debt, or $6 million. Debt financing requires
AP30 million. The annual interest payment is 14% of AP30 million = AP4,000,000.
Year 0 Year 1 Year 2 Year 3 Year 4
Revenue AP10,000,000 AP10,000,000 AP10,000,000 AP10,000,000
Operating
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Multinational Cost of Capital and Capital Structure 2
payments
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.
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
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Multinational Cost of Capital and Capital Structure 3
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:
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:
ke=Rf+B(Rm−Rf)
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:
ke=Rf+B(Rm−Rf)
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Multinational Cost of Capital and Capital Structure 4
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:
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.
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 U.S. risk-free interest rate rises.
Will the change in interest rates increase, decrease, or have no effect on the required rate of return on
the project? Briefly explain.
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 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.
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Multinational Cost of Capital and Capital Structure 5
CRITICAL THINKING
Tradeoffs Involved in MNC’s Capital Structure Decisions In recent years, some U.S.-based MNCs
(such as Apple) have taken advantage of the very low interest rates in the U.S. by borrowing large amount
of dollars to finance their operations. Write a short essay that explains the advantages and possible
disadvantages (if any) due to this type of financing. Consider how it affects the cost of capital. Consider
how it affects the capital structure, but keep in mind that the interest payments on debt borrowed at an
interest rate of 3% is different than interest rate payments on debt borrowed at 10%. Also, consider how it
affects the exposure to exchange rate risk if the funds borrowed are used to finance foreign operations.
ANSWER
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.
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
3. If Blades borrows funds in Thailand to support its Thai subsidiary, how would this affect its cost of
capital? Why?
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?
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
would likely have a higher risk-free rate since its inflation rate is usually much higher than
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Multinational Cost of Capital and Capital Structure 7
Hungary’s. The risk premium should probably be higher on the Hungarian venture because there is
more uncertainty about the revenue to be generated from that venture. However, the advantage on the
risk premium for the Mexican venture will be overwhelmed by the disadvantage on the risk-free rate.
Overall, the cost of financing the Mexican project will be higher.
b. While the Mexican venture will have higher financing costs, the Mexican subsidiary will not
necessarily experience lower returns. The high inflation that causes a high risk-free rate also can
inflate periodic cash flows. Thus, there may be an offsetting effect. Recall that the price of
computers in Mexico is tied to the inflation rate.
c. If the debt is backed by the parent, the creditors may be less inclined to charge a high risk premium.
d. The Hungarian subsidiary may have to pay a higher interest rate, because it would not have the
implicit backing of the Hungarian government. The Hungarian-owned companies could possibly
receive some government support if they experienced financial problems. Therefore, they may be
able to obtain funds at a lower cost.
e. The risk-free interest rate is likely to rise in response to an increase in inflation. Therefore, the cost of
funds should rise as well. The cost of production may also rise by a similar degree. The revenue
from selling the computers is not tied to Hungarian inflation because the computers are sold in other
countries. Those countries are not expected to experience inflated economies. Overall, the costs
should increase without any impact on revenue.
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.
The use of equity to support the subsidiary is especially effective if Jim did not have any other plan
for using the equity.
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?
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Multinational Cost of Capital and Capital Structure 8
dollar-denominated debt could be much higher if the pound weakens over time (because it would take
more pounds to convert to dollars to make the interest payments).
3.How can the equity proportion of this firm’s capital structure increase over time after it is more
established?
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