Question

1. Suppose the domestic U.S. beta of IBM is 1.0, the expected return on the U.S. market portfolio is 12 percent, and that the U.S. T-bill rate is 6 percent. At same time, suppose the world beta measure of IBM is 0.80 and the expected return on the world market portfolio is 14%.
   1. Find the cost of equity capital for IBM assuming that the U.S. market is fully integrated.
   2. Find the cost of equity capital for IBM assuming that the U.S. market is segmented
2. Blues, Inc. is a multinational corporation based in the U.S. Blues would like to estimate its weighted average cost of capital. On average, Blues pays a pre-tax rate of 9 percent for its debt. Currently, T-bill rates are 3 percent. The return on the S&P 500 stock index is expected to be 10 percent and the return on the world market portfolio is expected to be 14 percent. Furthermore, Blues’ stock has a domestic U.S. beta of 1.5 and a world beta of 1.2. Blues’ target capital structure is 30 percent debt and 70 percent equity. If Blues is in the 35 percent tax bracket,
   1. what is its weighted average cost of capital assuming that the U.S. market is fully integrated?
   2. what is its weighted average cost of capital assuming that the U.S. market is segmented?

Answer 1

1.a.cost of equity capital for IBM assuming that the U.S. market is fully integrated, then we have to take world beta because the risk factor is common across the globe.

Cost of equity=risk free rate+(Beta*(expected rate of return-riskfree rate))

Treasury bills rate of 6.0% is taken as risk free rate.

world market risk premium=(14%-6%)=8%

World beta of IBM=0.8

Cost of equity=6%+(0.8*8%)=12.4%

b. cost of equity capital for IBM assuming that the U.S. market is segmented, then we need to take beta of 1.0 and the expected US market return of 12%

Cost of equity=6%+(1.0*(12%-6%))=12%

2. pre tax cost of debt=9%

After tax cost of debt=pre tax cost of debt*(1-tax rate)=9%*(1-35%)=5.85%

Cost of equity if US market is fully integrated, we should take world beta:1.2 and world market expected return of 14%

Cost of equity=risk free rate+(Beta*(expected rate of return-riskfree rate))

=3%+(1.2*(14%-3%))=16.2%

a.Weighted average cost of capital=(weight of equity*cost of equity)+(weight of debt*after tax cost of debt)

=(70%*16.2%)+(30%*5.85%)

=13.10%

b. Cost of equity if US market is segmented, we should take domestic beta:1.4 and domestic market expected return of 10%

Cost of equity=risk free rate+(Beta*(expected rate of return-riskfree rate))

=3%+(1.4*(10%-3%))=12.8%

Weighted average cost of capital=(weight of equity*cost of equity)+(weight of debt*after tax cost of debt)

=(70%*12.8%)+(30%*5.85%)

=10.72%