Question

Your firm has EUR 100 million of outstanding equity. It has also issued a 10-year bond in US markets with total face value equal to USD 100 million, which pays a 4% annual coupon and was recently quoted at a price of 100. Your marginal tax rate is 25%.

You observe the market information below.

EUR risk-free rate 2%
Your firm's beta 1.25
Market risk premium 4%
EUR expected inflation 1%
USD expected inflation 3%
Exchange rate 1.10 USD per EUR

Your firm’s weighted average cost of capital (in USD terms) is closest to:

Answer 1

As per CAPM, the cost of equity (Ke) can be computed as follows:

Ke = Rf + Beta * Market risk premium

= 2% + 1.25 * 4%

= 7%

Cost of debt (Kd) can be computed as follows:

Kd = [I(1-t) * (F - P)/10] / (F+P) /2

= [4(1-0.25) * (100-100)/10] /(100+100)/2

= 3%

According to PPT theory, forward rate can be computed as follows:

Forward rate / Spot rate = (1+Inflation of domestic country) / (1+Inflation of foreign country)

Forward rate / $1.10 = (1+0.01) / (1+0.03)

Forward rate = $1.08

Computation of WACC

Type	Amount in local currency	Exchange rate	Equivalent amount in USD	Weights (A)	Cost of capital (net of tax) (B)	Weighted average cost of capital (A) * (B)
Equity	100	1.08	108	0.52	7.0%	3.63%
Debt	100	1	100	0.48	3.0%	1.44%
			208			5.08%

Firm's WACC is 5.08%.