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?
Assumptions
Corcovado's beta
Cost of debt, before tax
Risk-free rate of interest
Corporate income tax rate
General return on market portfolio
Optimal capital structure:
Proportion of debt, D/V
Proportion of equity, E/V

a.

Values
1.10
7.000%
3.000%
25.000%
8.000%

b.

Values
0.80
7.000%
3.000%
25.000%
8.000%

60%
40%

60%
40%

Cost of debt, after-tax

kd x ( 1 - t )

5.250%

5.250%

Cost of equity, after-tax

ke = krf + ( km - krf )

8.500%

7.000%

WACC
WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

6.550%

5.950%

Calculation of the WACC

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
Combined federal and state tax rate
Desired capital structure:
Proportion debt
Proportion equity
Capital to be raised

Costs of Raising Capital in the Market

Up to $40 million of new capital
$41 million to $80 million of new capital
Above $80 million

a. To raise $120,000,000
First $40,000,000
Second $40,000,000
Third $40,000,000

Values
40%
50%
50%
$ 120,000,000
Cost of
Domestic
Equity
12%
18%
22%

Debt Market
European
European
Domestic

Weighted average cost

b. To raise $60,000,000
First $40,000,000
Additional $20,000,000
Weighted average cost

Cost of
Domestic
Debt
8%
12%
16%

Debt Cost
6.00%
10.00%
16.00%

Cost of
European
Equity
14%
16%
24%

Equity Market
Domestic
European
Domestic

10.67%
(equal weights)

Debt Market
European
European

Debt Cost
6.00%
10.00%
7.33%
(2/3 & 1/3 weights)

Equity Market
Domestic
European

Cost of
European
Debt
6%
10%
18%

Equity Cost

Incremental
WACC

12.00%
16.00%
22.00%

7.80%
11.00%
15.80%

16.67%
(equal weights)

11.53%

Equity Cost

Incremental
WACC

12.00%
16.00%

7.80%
11.00%

13.33%
(2/3 & 1/3 weights)

8.87%

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
CAPM
1.05
3.60%
4.40%
8.00%
35%
9.00%

International
ICAPM
0.85
3.60%
4.40%
8.00%
35%
8.00%

30%
70%

30%
70%

a) Trident's cost of equity

ke = krf + ( km - krf )

9.270%

7.340%

b) Trident's cost of debt, after tax

kd x ( 1 - t )

5.200%

5.200%

c) Trident's weighted average cost of capital

WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

8.049%

6.6980%

Assumptions
Trident's beta,
Risk-free rate of interest, krf
Company credit risk premium
Cost of debt, before tax, kd
Corporate income tax rate, t
General return on market portfolio, km
Optimal capital structure:
Proportion of debt, D/V
Proportion of equity, E/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%
b. 7.00%

c. 5.00%
d. 4.00%

Assumptions
Trident's beta,
Risk-free rate of interest, krf
Company credit risk premium
Cost of debt, before tax, kd
Corporate income tax rate, t
Equity risk premium
General return on market portfolio, km
Optimal capital structure:
Proportion of debt, D/V
Proportion of equity, E/V

Answer for part a

Domestic
International
CAPM
ICAPM
1.05
0.85
4.00%
4.00%
4.40%
4.40%
8.40%
8.40%
35%
35%
8.00%
8.00%
12.00%
12.00%
30%
70%

30%
70%

12.400%

10.800%

5.460%

5.460%

10.318%

9.198%

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%

a) Trident's cost of equity

ke = krf + ( km - krf )
b) Trident's cost of debt, after tax
kd x ( 1 - t )
c) Trident's weighted average cost of capital
WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

Differing Equity Risk Premiums

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:

Estimate of correlation between security and market

jm
0.90
0.85
Estimate of standard deviation of Tata's returns
j
24.0%
30.0%
Estimate of standard deviation of market's return
m
18.0%
22.0%
Risk-free rate of interest
Estimate of Tata's cost of debt in US market
Estimate of market return, forward-looking
Corporate tax rate
Proportion of debt
Proportion of equity

krf
kd
km
t
D/V
E/V

3.0%
7.5%
9.0%
35.0%
35%
65%

3.0%
7.8%
12.0%
35.0%
40%
60%

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

1.20

1.16

Estimated cost of equity

ke = krf + (km - krf)

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%

Estimating Costs of Capital

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.

Assumptions
Total sales
Company's beta
Company credit rating
Risk-free rate of interest
Market risk premium
Weighted average cost of debt
Corporate tax rate
Debt to total capital ratio
Equity to total capital ratio
International sales as % of total sales

Symbol
Sales

S&P
krf
km-krf
kd
t
D/V
E/V

Estimating Costs of Capital

Symbol

Cost of equity
ke = krf + (km - krf)
Cost of debt, after-tax
Weighted average cost of capital
WACC = (ke x E/V) + ( (kd x (1-t)) x D/V)

Comparables
Company A
Company B
$10.5 billion
$45 billion
0.83
0.68
AA
A
4.5%
4.5%
5.5%
5.5%
6.885%
7.125%
48.0%
48.0%
34%
41%
66%
59%
11%
34%

Cargill
$113 billion
0.90
AA
4.5%
5.5%
6.820%
48.0%
28%
72%
54%

Company A

Company B

Cargill

ke

9.065%

8.240%

9.450%

kd ( 1 - t )

3.580%

3.705%

3.546%

WACC

7.200%

6.381%

7.797%

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 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 Performance

Inflation rate (IPC)
Bank lending rate
Exchange rate (reais/$)
Equity returns (Sao Paulo Bovespa)

1995
23.20%
53.10%
0.972
16.0%

1996
10.00%
27.10%
1.039
28.0%

1997
4.80%
24.70%
1.117
30.2%

1998
1.00%
29.20%
1.207
33.5%

1999
10.50%
30.70%
1.700
151.9%

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.

Mean
9.90%
32.96%
120.7%
51.92%

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.
Before
After
Assumptions
Symbol
Diversification
Diversification
Correlation between G-H and the market
jm
0.88
0.76
Standard deviation of G-H's returns
j
28.0%
26.0%
Standard deviation of market's returns
m
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
= ( jm x j ) / ( m )

1.37

1.10

Estimated cost of equity

ke = krf + (km - krf)

ke

10.529%

9.038%

ke + RPM

10.529%

12.038%

Estimated cost of equity with additional risk premium

ke* = krf + (km - krf) + RPM

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 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?

Assumptions
Correlation between G-H and the market
Standard deviation of G-H's returns
Standard deviation of market's returns
Risk-free rate of interest
Additional equity risk premium for internationalization
Estimate of G-H's cost of debt in US market
Market risk premium
Corporate tax rate
Proportion of debt
Proportion of equity

Symbol
jm
j
m
krf
RPM
kd
km-krf
t
D/V
E/V

Estimating Costs of Capital

Before
Diversification
0.88
28.0%
18.0%
3.0%
0.0%
7.2%
5.5%
35.0%
38%
62%

After
Diversification
0.76
26.0%
18.0%
3.0%
3.0%
7.0%
5.5%
35.0%
32%
68%

Before
Diversification

After
Diversification

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

1.37

1.10

Estimated cost of equity

ke = krf + (km - krf)

ke

10.529%

9.038%

ke + RPM

10.529%

12.038%

4.680%

4.550%

8.306%

7.602%

8.306%

9.642%

Estimated cost of equity with additional risk premium

ke* = krf + (km - krf) + RPM
Cost of debt, after-tax
kd ( 1 - t )

kd (1-t)

Weighted average cost of capital

WACC = (ke x E/V) + ( (kd x (1-t)) x D/V)

WACC

Weighted average cost of capital with RPM

WACC = (ke* x E/V) + ( (kd x (1-t)) x D/V)

WACC*

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?

Assumptions
Correlation between G-H and the market
Standard deviation of G-H's returns
Standard deviation of market's returns
Risk-free rate of interest
Additional equity risk premium for internationalization
Estimate of G-H's cost of debt in US market
Market risk premium
Corporate tax rate
Proportion of debt
Proportion of equity

Symbol
jm
j
m
krf
RPM
kd
km-krf
t
D/V
E/V

Estimating Costs of Capital

Before
Diversification
0.88
28.0%
18.0%
3.0%
0.0%
7.2%
5.5%
35.0%
38%
62%

After
Diversification
0.76
26.0%
18.0%
3.0%
3.0%
7.0%
5.5%
32.0%
32%
68%

Before
Diversification

After
Diversification

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

1.37

1.10

Estimated cost of equity

ke = krf + (km - krf)

ke

10.529%

9.038%

ke + RPM

10.529%

12.038%

4.680%

4.760%

8.306%

7.669%

8.306%

9.709%

Estimated cost of equity with additional risk premium

ke* = krf + (km - krf) + RPM
Cost of debt, after-tax
kd ( 1 - t )

kd (1-t)

Weighted average cost of capital

WACC = (ke x E/V) + ( (kd x (1-t)) x D/V)

WACC

Weighted average cost of capital with RPM

WACC = (ke* x E/V) + ( (kd x (1-t)) x D/V)

WACC*

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.