All rates are stated as annual rates.
A U.S. company is considering a project that would require a direct investment to build a manufacturing plant in the foreign country, Nearland. There is a publicly traded Nearlandi company, S Co, that operates in Nearland in the same industry as the U.S. company.
The Nearlandi equity market is highly segmented. The U.S. company has collected a series of returns on S Co, on the Nearlandi equity market, and on the world equity market, and calculated correlation coefficients and standard deviations as follows:
rS Co, Nearland = 0.765
rS Co, World = 0.495
sS Co = 0.60
s Nearland = 0.34
1. What is the Nearland beta for S Co?
2. If the risk free interest rate and average equity market return in Nearland are 4.8% and 16.3%, what is the required return on S Co stock in the Nearland market?
3. What is the world beta for S Co?
4. If the world risk free interest rate is 1.5% and the average return on the world equity market is 12.7%, what would the required return on S Co stock be if it traded in a fully integrated, rather than a segmented market?
5. Nearland law bars S Co from raising equity in non-domestic markets, but the U.S. firm proposing to develop a manufacturing plant in Nearland is not subject to that restriction. Which required return (from question 2 or 4) will equity investors of the U.S. firm demand on funds invested in the proposed project?
6. If Nearland’s corporate tax rates is the same as the U.S. corporate tax rate (35%) and the U.S. firm plans to fund 30% of the project with debt that has an interest rate of 6%, what will its weighted average cost of capital be for the project? (Assume that the S Co betas calculated are for firms with similar leverage.)
7. A firm is considering a foreign investment in a country with equity market that is somewhat integrated with other developed countries’ equity markets. The firm’s beta for a particular project is 1.65; the risk free and market returns in the firm’s domestic market 1.25% and 12.0%, respectively. If the expected inflation rate in the firm’s domestic market is 2.2% and the foreign expected inflation rate (in the country where the project is to be located) is 6.5%, what return should the firm require on the foreign project using the shortcut method that accounts only for the inflation differential?
8. Assume the same facts as in question 7, and that the standard deviation of returns on the foreign equity and risk free debt markets of 0.425 and 0.155, respectively, and the risk free rate in foreign country is 2.75%. What return should the firm require on the foreign project if it accounts for the country risk premium (rather than just the inflation differential)?
ra,b is the correlation coefficient between returns on a and and returns on b
sa is the standard deviation of returns on a
Betaproject (bproject)= covariance(rproject, rmarket)/variance(rmarket)
covariance(ra, rb) = ra,b*sa*sb