Problem 13.

1 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.

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

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 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 13.2 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?

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 13.3 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 equity

b. Trident's cost of debt
c. Trident's weighted average cost of capital
Domestic International
Assumptions CAPM ICAPM
Trident's beta, β 1.05 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) Trident's cost of equity 9.270% 7.340%

ke = krf + ( km - krf ) β

b) Trident's cost of debt, after tax 5.200% 5.200%

kd x ( 1 - t )

c) Trident's weighted average cost of capital 8.049% 6.6980%

WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]
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 a
Domestic International
Assumptions CAPM ICAPM
Trident's beta, β 1.05 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) Trident's cost of equity 12.400% 10.800%

ke = krf + ( km - krf ) β

b) Trident's cost of debt, after tax 5.460% 5.460%

kd x ( 1 - t )

c) Trident'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 13.5 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.):
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 Tata's returns σj 24.0% 30.0%
Estimate of standard deviation of market's return σm 18.0% 22.0%

Risk-free rate of interest krf 3.0% 3.0%

Estimate of Tata'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 ) β 1.20 1.16

Estimated cost of equity

ke = krf + (km - krf) β ke 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 13.6 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.

Comparables
Assumptions Symbol Company A Company B Cargill
Total sales Sales $10.5 billion $45 billion $113 billion
Company's beta β 0.83 0.68 0.90
Company credit rating S&P AA A AA
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) β ke 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 13.7 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 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.”

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 week’s debate at the Tombs.

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 13.8 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 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.
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 σm 18.0% 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 ) β 1.37 1.10

Estimated cost of equity

ke = krf + (km - krf) β ke 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 in which 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 would
indeed be higher, 12.038% compared to the before value of 10.529%.
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 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 8 (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 σm 18.0% 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 ) β 1.37 1.10

Estimated cost of equity

ke = krf + (km - krf) β ke 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, the firm's 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 13.10 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?

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 σm 18.0% 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 ) β 1.37 1.10

Estimated cost of equity

ke = krf + (km - krf) β ke 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 affects 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.