BUS322 TMA TMB TMD 2014 TUT08 CH13

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Problem 13.1 Corcovado Pharmaceuticals

Corcovado Pharmaceuticals 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, Corcovados effective tax rate is 25%. Its optimal capital structure is 60% debt and 40% equity.

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

b. If Corcovados 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?

Assumptionsa. Valuesb. ValuesCorcovado's beta1.100.80Cost of debt, before tax7.000%7.000%Risk-free rate of interest3.000%3.000%Corporate income tax rate25.000%25.000%General return on market portfolio8.000%8.000%

Optimal capital structure: Proportion of debt, D/V60%60% Proportion of equity, E/V40%40%

Calculation of the WACC

Cost of debt, after-tax5.250%5.250% kd x ( 1 - t )

Cost of equity, after-tax8.500%7.000% ke = krf + ( km - krf )

WACC6.550%5.950% WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

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Problem 13.2 Colton Conveyance, Inc.

Colton Conveyance, Inc., is a large U.S. natural gas pipeline company that wants to raise $120 million to finance expansion. Deming wants a capital structure that is 50% debt and 50% equity. Its corporate combined federal and state income tax rate is 40%. Deming 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, each, of debt and equtiy if raised half by equity and half by debt.

A London bank advises Deming 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.

Each increment of cost would be influenced by the total amount of capital raised. That is, if Deming 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 Deming raises $20 million in the equity market and an additional $20 in the debt market at the same time.

b. If Deming 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?

AssumptionsValuesCombined federal and state tax rate40%Desired capital structure: Proportion debt50% Proportion equity50%Capital to be raised$120,000,000

Cost ofCost ofCost ofCost ofDomesticDomesticEuropeanEuropeanCosts of Raising Capital in the MarketEquityDebtEquityDebtUp to $40 million of new capital12%8%14%6%$41 million to $80 million of new capital18%12%16%10%Above $80 million22%16%24%18%

Incrementala. To raise $120,000,000 Debt MarketDebt CostEquity MarketEquity CostWACC

First $40,000,000European6.00%Domestic12.00%7.80%Second $40,000,000European10.00%European16.00%11.00%Third $40,000,000Domestic16.00%Domestic22.00%15.80%

Weighted average cost10.67%16.67%11.53%(equal weights)(equal weights)

Incrementalb. To raise $60,000,000Debt MarketDebt CostEquity MarketEquity CostWACC

First $40,000,000European6.00%Domestic12.00%7.80%Additional $20,000,000European10.00%European16.00%11.00%

Weighted average cost7.33%13.33%8.87%(2/3 & 1/3 weights)(2/3 & 1/3 weights)

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Problem 13.3 Trident's Cost of Capital

Market conditions have changed. 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 at .85, and the company's capital structure is now 30% debt. All other values remain the same. For both the domestic CAPM and ICAPM, calculate:

a. Trident's cost of equityb. Trident's cost of debtc. Trident's weighted average cost of capitalDomesticInternationalAssumptionsCAPMICAPMTrident's beta, 1.050.85Risk-free rate of interest, krf3.60%3.60%Company credit risk premium4.40%4.40%Cost of debt, before tax, kd8.00%8.00%Corporate income tax rate, t35%35%General return on market portfolio, km9.00%8.00%Optimal capital structure: Proportion of debt, D/V30%30% Proportion of equity, E/V70%70%

a) Trident's cost of equity9.270%7.340% ke = krf + ( km - krf )

b) Trident's cost of debt, after tax5.200%5.200% kd x ( 1 - t )

c) Trident's weighted average cost of capital8.049%6.6980% WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

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Problem 13.4 Trident and Equity Risk Premiums

Using the original cost of capital data for Trident used in the chapter, calculate both the CAPM and ICAPM costs of capital for the following equity risk premium estimates.

a. 8.00% c. 5.00%b. 7.00% d. 4.00%Answer for part aDomesticInternationalAssumptionsCAPMICAPMTrident's beta, 1.050.85Risk-free rate of interest, krf4.00%4.00%Company credit risk premium4.40%4.40%Cost of debt, before tax, kd8.40%8.40%Corporate income tax rate, t35%35%Equity risk premium8.00%8.00%General return on market portfolio, km12.00%12.00%Optimal capital structure: Proportion of debt, D/V30%30% Proportion of equity, E/V70%70%

a) Trident's cost of equity12.400%10.800% ke = krf + ( km - krf )

b) Trident's cost of debt, after tax5.460%5.460% kd x ( 1 - t )

c) Trident's weighted average cost of capital10.318%9.198% WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

Differing Equity Risk PremiumsCAPMICAPM

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%

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Problem 13.5 Kashmiri's Cost of Capital

Kashmiri is the largest and most successful specialty goods company based in Bangalore, India. It has not entered the North American marketplace yet, 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.):AssumptionsSymbolGoldman SachsBank of New YorkComponents of beta: Estimate of correlation between security and marketjm0.900.85 Estimate of standard deviation of Tata's returnsj24.0%30.0% Estimate of standard deviation of market's returnm18.0%22.0%

Risk-free rate of interestkrf3.0%3.0%Estimate of Tata's cost of debt in US marketkd7.5%7.8%Estimate of market return, forward-lookingkm9.0%12.0%Corporate tax ratet35.0%35.0% Proportion of debtD/V35%40% Proportion of equityE/V65%60%

Estimating Costs of Capital

Estimated beta = ( jm x j ) / ( m )1.201.16

Estimated cost of equity ke = krf + (km - krf) ke10.200%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)WACC8.336%10.087%

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Problem 13.6 Cargill's Cost of Capital

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 "guesstimate" of what you believe a comparable WACC would be for Cargill.

ComparablesAssumptionsSymbolCompany ACompany BCargillTotal salesSales$10.5 billion$45 billion$113 billionCompany's beta0.830.680.90Company credit ratingS&PAAAAARisk-free rate of interestkrf4.5%4.5%4.5%Market risk premiumkm-krf5.5%5.5%5.5%Weighted average cost of debtkd6.885%7.125%6.820%Corporate tax ratet48.0%48.0%48.0%Debt to total capital ratioD/V34%41%28%Equity to total capital ratioE/V66%59%72%International sales as % of total sales11%34%54%

Estimating Costs of CapitalSymbolCompany ACompany BCargill

Cost of equity ke = krf + (km - krf) ke9.065%8.240%9.450%

Cost of debt, after-taxkd ( 1 - t )3.580%3.705%3.546%

Weighted average cost of capitalWACC7.200%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 another2. Credit rating and cost of debt do follow expected norms; lower the rating, the higher the cost3. Both comparable companies, in the same industry as Cargill (commodities), possess relatively low betas4. Cargill's sales are twice that of the next largest firm5. 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 fallbetween 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 of0.90 is shown here giving a WACC of 7.797%. A series of sensitivities would find a WACC between 7.1% and 7.9%.

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Problem 13.7 The Tombs

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 table is then the subject of the analysis.

Larry argues that it's 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.

Moe interrupts: But youre missing the point. The cost of capital is what the investor requires in compensation for the risk taken going into the investment. If he doesnt end up getting it, and that was happening here, then he pulls his capital out and walks.

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 with 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.

At this point both Larry and Mo simply stare at Curly, pause, and order more beer. Using the Brazilian data presented, comment on this weeks debate at the Tombs.

Brazilian Economic Performance19951996199719981999MeanInflation rate (IPC)23.20%10.00%4.80%1.00%10.50%9.90%Bank lending rate53.10%27.10%24.70%29.20%30.70%32.96%Exchange rate (reais/$)0.9721.0391.1171.2071.700120.7%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.

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Problem 13.8 Genedak-Hogan Cost of Equity

Use the following information to answer questions 8 through 10. Genedak-Hogan is an American conglomerate that 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. Although both parties agree that the companys 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.

BeforeAfterAssumptionsSymbolDiversificationDiversificationCorrelation between G-H and the marketjm0.880.76Standard deviation of G-H's returnsj28.0%26.0%Standard deviation of market's returnsm18.0%18.0%Risk-free rate of interestkrf3.0%3.0%Additional equity risk premium for internationalizationRPM0.0%3.0%Estimate of G-H's cost of debt in US marketkd7.2%7.0%Market risk premiumkm-krf5.5%5.5%Corporate tax ratet35.0%35.0% Proportion of debtD/V38%32% Proportion of equityE/V62%68%

Estimating Costs of Capital

Estimated beta = ( jm x j ) / ( m )1.371.10

Estimated cost of equity ke = krf + (km - krf) ke10.529%9.038%

Estimated cost of equity with additional risk premium ke* = krf + (km - krf) + RPMke + RPM10.529%12.038%

This may be a case in which everyone is correct. When G-H's beta is recalculated, it falls in value as a result ofthe reduced correlation of its returns with the home market (diversification benefit). This then creates a standard cost ofequity, 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 internationallydiversifying operations, and if that risk premium were on the order of 3.0%, the final risk-adjusted cost of equity wouldindeed be higher, 12.038% compared to the before value of 10.529%.

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Problem 13.9 Genedak-Hogan's WACC

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

a. Did the reduction in debt costs reduce the firms 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 8 (an added 3.0% to the cost of equity because of international diversification), what is the firms WACC?

BeforeAfterAssumptionsSymbolDiversificationDiversificationCorrelation between G-H and the marketjm0.880.76Standard deviation of G-H's returnsj28.0%26.0%Standard deviation of market's returnsm18.0%18.0%Risk-free rate of interestkrf3.0%3.0%Additional equity risk premium for internationalizationRPM0.0%3.0%Estimate of G-H's cost of debt in US marketkd7.2%7.0%Market risk premiumkm-krf5.5%5.5%Corporate tax ratet35.0%35.0% Proportion of debtD/V38%32% Proportion of equityE/V62%68%

BeforeAfterEstimating Costs of CapitalDiversificationDiversification

Estimated beta = ( jm x j ) / ( m )1.371.10

Estimated cost of equity ke = krf + (km - krf) ke10.529%9.038%

Estimated cost of equity with additional risk premium ke* = krf + (km - krf) + RPMke + RPM10.529%12.038%

Cost of debt, after-taxkd (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 RPMWACC* 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, the firm's access to debthas 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.

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Problem 13.10 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?

BeforeAfterAssumptionsSymbolDiversificationDiversificationCorrelation between G-H and the marketjm0.880.76Standard deviation of G-H's returnsj28.0%26.0%Standard deviation of market's returnsm18.0%18.0%Risk-free rate of interestkrf3.0%3.0%Additional equity risk premium for internationalizationRPM0.0%3.0%Estimate of G-H's cost of debt in US marketkd7.2%7.0%Market risk premiumkm-krf5.5%5.5%Corporate tax ratet35.0%32.0% Proportion of debtD/V38%32% Proportion of equityE/V62%68%

BeforeAfterEstimating Costs of CapitalDiversificationDiversification

Estimated beta = ( jm x j ) / ( m )1.371.10

Estimated cost of equity ke = krf + (km - krf) ke10.529%9.038%

Estimated cost of equity with additional risk premium ke* = krf + (km - krf) + RPMke + RPM10.529%12.038%

Cost of debt, after-taxkd (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 RPMWACC* WACC = (ke* x E/V) + ( (kd x (1-t)) x D/V)8.306%9.709%

The reduction in the effective tax rate obviously affects WACC through the cost of debt. This does have substantialbenefits in the company's WACC -- as long as additional equity risk premiums are not assessed. Then, even the lowereffective tax rate does not offset the higher equity costs associated with the international risk premium.