Question

Assume that Walmart is considering opening a store in Argentina. Argentina is rate BB-, and its dollar-based bonds trade at a default spread of 3% over the US treasury bond rate of 6.5%. The Argentine equity market is 1.8 times more volatile than the Argentine long-term bond market. Walmart has a beta of 0.9 (already relevered to account for the Argentinian tax rate of 35% and Argentinian D/E ratio). The market risk premium in the United States is 5.5%. The firm intends to borrow in Argentina at a local rate of 12% (in pesos) and maintain a debt ratio of 25% for Argentine projects. You can assume that the inflation rate in the United States is 3% whereas it is 9% in Argentina.

(a)     Explain what we mean by “the inflation rate” in the above description.

(b)     Estimate the cost of equity and the cost of capital in dollar terms for the Argentine store.

3. Estimate the cost of equity and capital in peso terms of the Argentine store.

Answer 1

a). Inflation rate basically measures the change in purchasing power of a currency from one time period to another. If an item today costs $90 then its cost after one year will not be $90 but would have increased (as is expected in an economy functioning normally). This change in cost is explained using inflation.

b). Country risk premium for Argentina = default spread of dollar-based bonds*relative volatility of Argentine equity market to bond market = 3%*1.8 = 5.40%

Cost of equity = US T-bond rate + beta*(market risk premium + country risk premium)

= 6.5% + 0.9*(5.5%+5.40%) = 16.31%

Cost of debt (in $) = (1 + Cost of debt in pesos)*[(1 + inflation rate_U.S.)/(1 + inflation rate_Argentina)] -1

= (1+12%)*[(1+3%)/(1+9%)] -1 = 5.83%

D/E ratio = 25% so E/V = 1/(1+25%) = 0.80

D/V = 1 - E/V = 1-0.80 = 0.20

Cost of capital in US$ = E/V*cost of equity + D/V*cost of debt*(1 - Tax rate)

= (0.80*16.31%) + (0.20*5.83%*(1-35%)) = 13.81%

c). Cost of equity in pesos = (1 + cost of equity in $ terms)*[(1 + inflation rate_Argentina)/(1 + inflation rate_U.S.)] -1

= (1+16.31%)*[(1+ 9%)/(1+3%)] - 1 = 23.09%

D/V and E/V ratios remains the same. Pre-tax cost of debt is now 12%

Cost of capital in pesos = E/V*cost of equity + D/V*cost of debt*(1 - Tax rate)

= (0.80*23.09%) + (0.2*12%*(1-35%)) = 20.03%