WEEK 7

Ex 34-36

Answer problems 34-36 based on the stock market data given by the following table.

Correlation Coefficients

Mechel Russia World SD(%) R (%)

Mechel 1.00 .90 0.60 20 ?

Russia 1.00 0.75 15 11

World 1.00 10 9

The above table provides the correlations among Mechel OAO, a Russian mining and steel company,
the Russian stock market index, and the world market index, together with the standard deviations
(SD) of returns and the expected returns ( R ). The risk-free rate is 4%.

34. Compute the domestic country beta of Mechel as well as its world beta. What do these betas
measure?

35. Suppose the Russian stock market is segmented from the rest of the world. Using the CAPM
paradigm, estimate the equity cost of capital of Mechel.

36. Suppose now that Mechel has made its shares tradable internationally via cross-listing on NYSE.
Again using the CAPM paradigm, estimate Mechels equity cost of capital. Discuss the possible effects
of international pricing of Mechel shares on the share prices and the firms investment decisions.

1
Solutions.

1. The domestic beta, MR , and the world beta, MW , of Mechel can be computed as follows:

MR M R MR (20)(15)(0.9) 270
MR = = = = = 1.20
R2 R2 (15) 2 225

MW M W MW (20)(10)(0.6) 120
MW = = = = = 1.20
W2 W2 (10) 2 100

Both the domestic and world beta turn out to be the same. As the market moves by 1%, Mechel stock
return will move by 1.20%

RM = R f + ( RR R f ) MR
2.
= 4 + (11 4)(1.20) = 12.40%

RM = R f + ( RW R f ) MW
3.
= 4 + (9 4)(1.20) = 10.00%

Cost of capital decrease

o Higher stock price
o Higher NPVs, ceteris paribus More investments

Exercise 37

Siam, Inc., a Thai company, has an optimal debt ratio of 35 percent. Its cost of equity capital is 14 percent and
its before-tax borrowing rate is 10 percent. Given a marginal tax rate of 30 percent, calculate (a) the weighted-
average cost of capital, and (b) the cost of equity for an equivalent all-equity financed firm.

Solution

(a) WACC = (E/A)*ke + (D/A)*kd*(1-tr) = (1 - 0.35)*0.14 + (0.35)*0.10*(1 - 0.30) = 0.1155

(b) M&M II: = + ( )(1 )

+ (1)
=
=
1+ (1) 1

2

= 1 = 0.538

Ku = (0.14 + 0.538*0.10*0.7)/(1+ 0.538*0.7) = 12.91%

Ku=0.1155/[1-0.30*0.35] = 12.91%

Exercise 38

Zeda, Inc., a US MNC, is considering making a fixed direct investment in Denmark. The Danish government has
offered Zeda a concessionary loan of DKK 15,000,000 at a rate of 4 percent per annum. The normal borrowing
rate for the Zeda is 6 percent in dollars and 5.5 percent in Danish krone. The load schedule calls for the
principal to be repaid in three equal annual installments. What is the present value of the benefit of the
concessionary loan? The current spot rate is DKK5.60/$1.00 and the expected inflation rate is 3 percent in the
US and 2.5 percent in Denmark.

Solution

1 + 1 +
1 = 0 0
1 + $ 1 + $

Int rate differential Inflation differential Approx

S1 5.573585 5.572816 5.57
S2 5.547294 5.545763 5.55
S3 5.521128 5.518842 5.52

I use alternatively

(i) Expected spot rate from uncovered interest rate parity; CF then discounted at i$ = 6%
(ii) Discount DNK CF at idnk= 5.5%, convert them to $ at S0.

(ii) (i)
(a) Princ. Pay Princ t-1 (b) interest CF (a) + (b) in DNK CF $ int PV DNK PV $
5000000 15000000 600000 5600000 1004739.336 5308056.872 947867.2986
5000000 10000000 400000 5400000 973447.5224 4851643.045 866364.8294
5000000 5000000 200000 5200000 941836.5356 4428391.054 790784.1167
TOT (DNK) 14588090.97
TOT ($) 2605016.245 2605016.245

DNK 15,000,000/5.60 = $ 2,678,571.429

3
Benefit = $ 2,678,571.429 $ 2,605,016.245 = $ 73,555.184

Exercise 39

Omega Industries, a U.S. MNC, is contemplating making a foreign capital expenditure in South Africa. The
initial cost of the project is ZAR 10,000. The annual cash flows over the five year economic life of the project in
ZAR are estimated to be 3,000, 4,000, 5,000, 6000, and 7,000. The parent firms cost of capital in dollars is 9.5
percent. Long-run inflation is forecasted to be 3 percent per annum in the U.S. and 7 percent in South Africa.
The current spot foreign exchange rate is ZAR/USD = 3.75. Determine the NPV for the project in USD by:

a. Calculating the NPV in ZAR using the ZAR equivalent cost of capital according to the Fisher Effect and then
converting to USD at the current spot rate.

b. Converting all cash flows from ZAR to USD at Purchasing Power Parity forecasted exchange rates and then
calculating the NPV at the dollar cost of capital. Are the two dollar NPVs different or the same? Explain.

c. What is the NPV in dollars if the actual pattern of ZAR/USD exchange rates is: S(0) = 3.75, S(1) = 5.7, S(2) =
6.7, S(3) = 7.2, S(4) = 7.7, and S(5) = 8.2?

Solution

a) ZAR equivalent cost of capital according to the Fisher Effect

1+ 1+
1+
= 1+ [(1+Ius)*(1+inflsa)/(1+influs) ] -1= 1.095 x [(1.07)/(1.03)] 1 = 0.1375

NPVUSD = [ 10,000 + 3,000/(1.1375)1 + 4,000/(1.1375)2 + 5,000/(1.1375)3 + 6,000/(1.1375)4

+ 7,000/(1.1375)5]/3.75 = USD 1,700

b) The PPP forecasted ZAR/USD exchange rates are:

(1 + )
() = 0
(1 + )

ZAR/USD(1) = 3.90

ZAR/USD(2) = 4.05

ZAR/USD(3) = 4.20

ZAR/USD(4) = 4.37

ZAR/USD(5) = 4.54

NPVUSD = [(3,000/3.90)/(1.095)1 + 4,000/(4.05)/(1.095)2 + 5,000/(4.20)/(1.095)3

+ 6,000/(4.37)/(1.095)4 + 7,000/(4.54)/(1.095)5 10,000/(3.75)] = USD1,700

4
Method a) and b) equivalent as both rely on PPP to hold

c) NPVUSD = [(3,000/5.7)/(1.095)1 + 4,000/(6.7)/(1.095)2 + 5,000/(7.2)/(1.095)3

+ 6,000/(7.7)/(1.095)4 + 7,000/(8.2)/(1.095)5 10,000/(3.75)] = USD75.

Exercise 40 [Do not confuse pound with !!! 1 pound = 453.6 g]

Dorchester Ltd., is an old-line confectioner specializing in high-quality chocolates. Through its facilities in
the United Kingdom, Dorchester manufactures candies that it sells throughout Western Europe and North
America (United States and Canada). With its current manufacturing facilities, Dorchester has been unable to
supply the U.S. market with more than 225,000 pounds of candy per year. This supply has allowed its sales
affiliate, located in Boston, to be able to penetrate the U.S. market no farther west than St. Louis and only as
far south as Atlanta. Dorchester believes that a separate manufacturing facility located in the United States
would allow it to supply the entire U.S. market and Canada (which presently accounts for 65,000 pounds per
year). Dorchester currently estimates initial demand in the North American market at 390,000 pounds, with
growth at a 5 percent annual rate. A separate manufacturing facility would, obviously, free up the amount
currently shipped to the United States and Canada. But Dorchester believes that this is only a short-run
problem. They believe the economic development taking place in Eastern Europe will allow it to sell there the
full amount presently shipped to North America within a period of five years.

Dorchester presently realizes 3.00 per pound on its North American exports. Once the U.S.
manufacturing facility is operating, Dorchester expects that it will be able to initially price its product at $7.70
per pound. This price would represent an operating profit of $4.40 per pound. Both sales price and operating
costs are expected to keep track with the U.S. price level; U.S. inflation is forecast at a rate of 3 percent for the
next several years. In the U.K., long-run inflation is expected to be in the 4 to 5 percent range, depending on
which economic service one follows. The current spot exchange rate is $1.50/1.00. Dorchester explicitly
believes in PPP as the best means to forecast future exchange rates.

The manufacturing facility is expected to cost $7,000,000. Dorchester plans to finance this amount by a
combination of equity capital and debt. The plant will increase Dorchesters borrowing capacity by 2,000,000,
and it plans to borrow only that amount. The local community in which Dorchester has decided to build will
provide $1,500,000 of debt financing for a period of seven years at 7.75 percent. The principal is to be repaid
in equal installments over the life of the loan. At this point, Dorchester is uncertain whether to raise the
remaining debt it desires through a domestic bond issue or a Eurodollar bond issue. It believes it can borrow

5
pounds sterling at 10.75 percent per annum and dollars at 9.5 percent. Dorchester estimates its all-equity cost
of capital to be 15 percent.

6
 The U.S. Internal Revenue Service will allow Dorchester to depreciate the new facility over a seven-year
period. After that time the confectionery equipment, which accounts for the bulk of the investment, is
expected to have substantial market value.

Dorchester does not expect to receive any special tax concessions. Further, because the corporate tax
rates in the two countries are the same--35 percent in the U.K. and in the United States--transfer pricing
strategies are ruled out.

Should Dorchester build the new manufacturing plant in the United States?

Solution

Data

In real term UK more convenient:

5.98% or .0598 = (1.1075)/(1.045) - 1.0 versus
6.31% or .0631 = (1.095)/(1.03) - 1.0.
Ke = 15%
Depreciation = 7years. Tax rate =35%

DATA
Firm believes in PPP --> Used to compute E[St]
Current shipping (US + Canada) 290,000 pounds
Initial North American demand (t=1) 390,000 pounds
Yearly growth of NA demand 5%
Current revenues 3 /pound
Initial revenues with inv 7.7 $/pound
Operating profit 4.4 $/pound
Inflation US 3%
Inflation UK (c.a) 4.50%
So(/$) = 1/1.50 0.6666667 /$
I0 7000000 $
Total borrowing 2000000
Community loan amount (equal inst.) 1500000 $
Int rate of community loan 7.75%
Borrowing cost in US $ 9.50%
Borrowing cost in UK 10.75%
Ku 15%
Depreciation 7 years
Tax rate 35%
INITIAL INVESTMENT IN [7,000,000 / 1.5] 4,666,667

7
 t 1 2 3 4 5
DIFFERENTIAL OPERATING CASH FLOWS
A E[S] St-1 x [(1+ inf UK)/(1+ inf US)] 0.676 0.686 0.696 0.706 0.717
B Pre-tax op profit per pound ($) t-1 Op Prof x (1+infl US) 4.40 4.53 4.67 4.81 4.95
C Quantity sold (pound) t-1 sold x (1+ growth rate) 390,000 409,500 429,975 451,474 474,047
D Pre-tax op profit ($) BxC 1,716,000 1,855,854 2,007,106 2,170,685 2,347,596
E Pre-tax op profit () DxA 1,160,660 1,273,534 1,397,386 1,533,281 1,682,393
F Quantity sold in Europe max ((t/5) x 290,000; 0) 58,000 116,000 174,000 232,000 290,000
G Quantity lost 290,000 - F 232,000 174,000 116,000 58,000 0
H Lost sale per pound () Lost sale t-1 x (1+infl UK) 3.14 3.28 3.42 3.58 3.74
I Tot lost sale () GxH 727,320 570,037 397,126 207,498 0
J Diff. Pre-tax op prof () E-I 433,340 703,497 1,000,260 1,325,783 1,682,393
K After tax () J x (1-35%) 281,671 457,273 650,169 861,759 1,093,555
L PV () Discounted at Ku 244,931 345,764 427,497 492,714 543,690
Tot PV Op. Cash Flows () 3,068,304
DEPRECIATION TAX SHIELD
M Yearly amortization 7,000,000/7 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
N Tax shield () St x 35% x 1,000,000 236,731 240,179 243,677 247,225 250,826
O PV Tax shields () Discounted at K 213,753 195,816 179,384 164,330 150,541
Tot PV DDA tax shield () 1,168,066
CONCESSIONARY LOAN (benefit + tax shield)
P Principal payment ($) 1,500,000/7 214,286 214,286 214,286 214,286 214,286
Q Beg. of period Principal ($) t-1 Principal - P 1,500,000 1,285,714 1,071,429 857,143 642,857
R Interest rate ($) 7.75% x Q 116,250 99,643 83,036 66,429 49,821
S Payments () A x (R + P) 223,566 215,426 207,001 198,285 189,271
T PV () Discounted at K 201,866 175,635 152,385 131,800 113,597
U Tot PV Conc. Loan payment () 956,144
Benefit () $1,500,000 x S0 - U 43,856
V Tax shield () A x R x 35% 27,520 23,932 20,234 16,423 12,496
W PV Tax shields () 24,849 19,512 14,895 10,916 7,500
Tot PV Conc. Loan Tax shield () 84,351
REMAINING LOAN TAX SHIELD ( 1,000,000)
X Tax shield () 10.75% x 1,000,000 x 35% 37,625 37,625 37,625 37,625 37,625
Y PV Tax shields () Discounted at K 33,973 30,675 27,698 25,009 22,582
Tot PV rem. Loan tax shield () 178,738

FINAL SOLUTION
APV
I0 4,666,667
All PVs 4,458,964
APV -207,703
SOMETHING MISSING ??? --> TERMINAL VALUE!!!
APV x [(1+Ku)^7] in 552,494
TV above / S7 828,741 $

If the final sell can generate a final Cash flow

of at least $828,741, It will be worth doing
this investment