Question

A US multinational corporation (MNC) is evaluating a capital project for a Brazilian subsidiary. Project cost is 400 Million Brazilian Real (BR). 300 Million will be financed by debt and the remaining 100 Million by issuing equity. The benchmark 3-year Brazilian Treasury note is at 4.24% and the current corporate tax rate is 34%. The Brazilian Bovespa stock market index is up 31.58 % for the year, the firm decides to use this data.

The firm can borrow (pre-tax) in the Brazilian markets at 76 basis points (bps) over the 3-year Treasury rate. They compute a beta coefficient for their Brazilian market at 1.5.

1. Based on the above assumptions, compute the weights for debt and equity for the project. Each weight is the percentage of the capital devoted to each financing method.
   1. Debt: 0.75
   2. Equity: 0.25
2. Based on the above statistics, compute the after-tax cost of debt for the project.
   1. Cost of Debt = 5% (4.24 + .76)
   2. After Tax Cost of Debt = 0.033 (0.05 * ( 1 - .34))
   3. Interest Expense = 9.9 million (0.033 * 300mil)
   4. After Tax Cost of Debt = 6.534 million (9.9 * (1-0.34))
3. Using the CAPM, compute the cost of equity for the project.
4. Based on your answers in a, b and c, compute the WACC for the Brazilian project. (Round to 4 places).
5. The firm does an internal study and computes the internal rate of return on the project at 15%. Based on your answer in d, should the firm proceed with the project based on IRR and WACC? Explain your decision.
6. The current exchange rate is 4.24 Brazilian Real/USD 1. If he firm translated the cost of the project into home currency (USD) at this rate, what dollar cost would they book it at?

Answer 1

Answer (A):

(a) Weight for Debt = 300/400 = 0.75

(b) Weight for equity = 100 / 400 = 0.25

Answer (B) (a):

Cost of debt = Risk free rate + Premium = 4.24% + 0.76% = 5%

Cost of debt = 5%

Answer (B) (b):

After Tax Cost of Debt = 5% * ( 1 - 34%) = 3.3%

After Tax Cost of Debt = 3.3%

Answer (B) (c):

Interest Expense = 300 * 5% = $15 Million Brazilian Real (BR)

Interest expense = $15 Million Brazilian Real (BR)

Answer (B) (d):

After Tax Interest (cost of debt) = 15 * (1 - 34%) = $9.9 Million Brazilian Real (BR)

After Tax Interest (cost of debt) = $9.9 Million Brazilian Real (BR)

Answer (C):

Using the CAPM:

Cost of equity = Risk free rate + Beta * (Market rate of return - Risk free rate)

= 4.24% + 1.5 *(31.58% - 4.24%)

= 45.25%

Cost of equity = 45.25%

Answer (D):

WACC for the Brazilian project = Cost of equity * Weight of equity + After tax cost of debt * weight of debt

= 45.25% * 0.25 + 3.3% * 0.75

= 13.7875%

WACC for the Brazilian project = 13.7875% or 0.1379

Answer (E):

The firm should proceed with the project based on IRR and WACC

Reason:

We calculated in answer above:

WACC for the Brazilian project = 13.7875% or 0.1379

If IRR of the project is = 15%, then

IRR > WACC

As IRR is greater than WACC, project is acceptable and the firm should proceed with the project.

Answer (F):

The current exchange rate is 4.24 Brazilian Real/USD 1.

Cost in Brazilian Real (BR) = 400 million =BR 400,000,000

US Dollar cost they look at = 400000000 / 4.24 = $94,339,622.64

US Dollar cost they look at =US $94,339,622.64