Question

Cost of Foreign Debt Versus Equity. Time Inc. is a U.S. firm that has a large subsidiary in Indonesia. It wants to finance the subsidiary’s operations in Indonesia. However, the cost of debt is presently about 30 percent there for firms like Time or government agencies that have a very strong credit rating. A consultant suggests to Time that it should use equity financing there to avoid the high interest expense. He suggests that since Time’s cost of equity in the U.S. is about 14 percent, so the Indonesian investors should be satisfied with a return of about 14 percent as well. The consultant's advice is not logical. Why is it that Time’s cost of equity in Indonesia would not be less than Time’s cost of debt in Indonesia?

	The risk-free interest rate is about 30 percent so Indonesian investors are not going to invest in Verona Inc. for less than the risk-free rate.
	The risk-free interest rate is about 14 percent so Indonesian Investors are not going to invest in Verona Inc. for less than the risk-free rate.
	The risk-free rate has no affect on the answer.
	None of the above.

Answer 1

Answer - C is correct. The risk free rate has no affect on the answer. The reason behind this logic that risk free rate is same among all countries. So what makes the interest rate difference?

The interest rate of any country consist of Risk free rate + Inflation rate. Because if any investor wants to invest in any country he will get same return due to opposite effect on the currency. Suppose if any investor in U.S wants to invest india, he will get same return as if he would invest in his country due to opposite effect on currency.

A is incorrect - The cost of debt is 30%. It is not risk free rate. But risk free rate is part of cost of debt. The cost of debt can be calculated by Risk free + inflation + liquidity risk + default risk.

B is incorrect - The risk free rate is not 14%. Rather it is cost of equity in U.S. Generally people demand higher rate of return when they assumes more risk like default risk, liquidity risk, reinvestment risk and so on. In U.S. people have less risk because its a developed country and there are less chances of default but in Indonesia , you can pre assume if cost of debt is 30%, the cost of equity would be more higher