Question

IBM., a successful US-based MNC, is considering how to obtain funding for a project in Argentina during the next year. It considers the following information:
• US Risk free rate= 8%
• Argentine risk free rate=12%
• Risk premium on dollar-denominated debt provided by US creditors=3%
• Risk premium on peso-denominated debt provided by US creditors=5%
• Beta of project (expected sensitivity of project returns to US investors
response to the US market)=1.5
• Beta of project (expected sensitivity of project returns to AR investors
response to the AR market)=1.8
• Expected US market return=15%
• Expected AR market return=14%
• Us corporate tax rate=30%
• Argentine corporate tax rate =30%
Creditors will likely allow no more than 50 percent of the financing to be in the form of debt, which implies that equity must provide at least 50% of the financing that can be financed from subsidiary also. But financing fragment cannot be less than 20%.

Answer 1

First, understand that here IBM needs to expand it's operations in Argentina and wants to get fundings.

Now we need to answer following 2 questions: 1. Which country amongst US or Argentina provides the cheaper credit? 2. Which country will be providing higher returns on the project?

Note that tax rates in both the countries are same i.e. there will be a corporate tax charged @ 30 % in both the countries. Therefore both countries at par in this regard.

Answering 1. Note that Risk Premium on Peso Denominated Debt is 5% which means that this borrowing will be beneficial to the borrower in terms of the  return on investment made with this borrowing. And if we compare it with the US Denominated Borrowings that has risk premium of 3%, the Peso Denominated Debt should be preffered.

Answering 2. With the help of Capital Asset Pricing Model will calculate which country will be giving higher returns in terms of project:

CAPM model gives us the expected rate of return:

Expected Return = Risk Free Rate + Beta*(Market Rate - Risk Free Rate)

For US,

18.50%

=8%+1.5*(15%-8%)

For Argentina,

15.60%

=12%+1.8*(14%-12%)

Now here the project that gives the highest return is that of the US.

Thus overall if we look at the funding of the project - It is lucrative to invest into the US Markets because thought the debt premium is less, the returns much higher.

Lastly, here the funding mix cannot be determined except the fact that equity funding must be min of 50% & bowrrowing must be min of 20%. But definitely the mix of funding is always better because due to moderate borrowing the firm doesn't lose out on ownership in terms of stakes and borrowing does benefit in terms of the taxation benefits the organisation can get.