Cost of Capital and Foreign Exchange Rates

Cost Of Capital

You are in charge of the capital budgeting division of a U.S. diversified multinational firm. The
parent company's cost of capital is 16.5 percent, assuming a current borrowing interest rate of 14
percent, a marginal tax rate of 40 percent, and an optimal capital structure of 0.45 debt and 0.55
equity.

You are considering an investment in a subsidiary incorporated in country X. Your firm's policy is
to reflect risk of foreign undertakings in the hurdle rate, rather than to adjust projected cash flows
of these projects.

What hurdle rate would you apply to the proposed investment under each of the following
situations? If no specific rate can be calculated from the data given, you may express the
appropriate rate as being higher or lower than the parent's stated cost of capital, stating in each case
your reasons. You are to treat each case separately, rather than cumulatively. In situations where
you think that not enough information is provided, you may so state, but the missing data should be
indicated in each case.

a. The project in country X has a risk comparable to your firm's overall risk in its domestic
investments. Political risk is deemed to be insignificant, but you expect the currency of
country X to depreciate by an average of 1.5 percent annually against the U.S. dollar in the
next four or five years (assume efficient exchange markets).

b. Same assumptions as in situation (a) except that you can borrow in local financial markets at
10 percent, but you have reason to believe that exchange and capital markets are not efficient.

c. Your subsidiary in country X will be facing intense competition from local firms, which
consider a 20 percent return on investment as the minimum rate needed to attract funds from
investors. (Assume here that both the exchange and political risks are negligible.)

d. Your subsidiary in country X will be involved in new lines of business that are riskier, and in
which your management has had no past experience. Your beta is currently 1.4, while betas of
firms involved in the same activities as the project in country X is 1.8. Moreover, country X has
been known to impose restrictions and blockage on transfers by affiliates to their parent firms.
(Disregard the exchange risk in this case.)

e. The debt ratio norms for manufacturing industries in country X are radically different. For
subsidiary X, a capital structure consisting of 0.65 debt and 0.35 equity would not be unusual.
(Disregard both exchange and political risks in this situation.)

f. Cash flows to be generated by subsidiary X are negatively correlated with the company's
present cash flow pattern. Moreover, as stated in situation (e), the subsidiary could support a
higher debt ratio than indicated in the parent's optimal capital structure. There is a small
political risk involved, but in your judgment, it will be more than offset by these features.
(Ignore the exchange risk in this situation.)