Q1. Mae Kioko, an analyst with Oswald Technologies, is conducting a capital budgeting analysis on an investment the firm is considering making in Argentina. The project being considered is expected to cost $200 million, and should produce net cash flows of $50 million per year for the next seven years. Since Argentina is a developing market, Kioko believes that it is appropriate to include a country risk premium when calculating the cost of equity. Kioko has researched yields in Argentina, and has observed that Argentina’s 10-year government bond yield is 9.8%, compared to a 4.6% yield for a similar 10-year U.S. government bond. Kioko also observes that the annualized standard deviation of the Argentina Merval stock exchange is 36%, which is higher than both the standard deviation of the S& 500 at 18%, and the annualized standard deviation of Argentina’s dollar-denominated government debt at 25%. In addition to the country risk premium, Kioko is concerned about whether Oswald will need to issue new capital to finance the project, and the impact that it may have on the firm’s cost of capital. Kioko wants to maintain the firm’s target capital structure of 70% equity and 30% debt. Currently, Oswald has slightly more than 70% equity as a result of $20 million in excess retained earnings that Kioko plans to use for the project. If any new capital needs to be raised, Kioko estimates that the marginal cost of debt will increase if the firm needs more than $100 million in new equity capital. After conducting her analysis, Kioko makes the following statements to her supervisor.

Statement 1: The country risk premium we should add to the cost of equity to capture Argentina’s country risk is 10.40%.

Statement 2: If we have to raise new capital to take on the project, we should discount the cash flows at a higher cost of capital, because the amount of capital needed exceeds our marginal cost of capital breakpoint of $150 million.

How should Kioko’s supervisor respond to her statements?

          Statement 1                                   Statement 2

A)    Agree                                   Disagree

B)   Disagree                               Disagree

C)   Disagree                               Agree

Q2. In order to more accurately estimate the cost of equity for a company situated in a developing market, an analyst should:

A)   use the yield on the sovereign debt of the developing country instead of the risk free rate when using the capital asset pricing model (CAPM).

B)   add a country risk premium to the risk-free rate when using the capital asset pricing model (CAPM).

C)   add a country risk premium to the market risk premium when using the capital asset pricing model (CAPM).

答案和详解如下：

Q1. Mae Kioko, an analyst with Oswald Technologies, is conducting a capital budgeting analysis on an investment the firm is considering making in Argentina. The project being considered is expected to cost $200 million, and should produce net cash flows of $50 million per year for the next seven years. Since Argentina is a developing market, Kioko believes that it is appropriate to include a country risk premium when calculating the cost of equity. Kioko has researched yields in Argentina, and has observed that Argentina’s 10-year government bond yield is 9.8%, compared to a 4.6% yield for a similar 10-year U.S. government bond. Kioko also observes that the annualized standard deviation of the Argentina Merval stock exchange is 36%, which is higher than both the standard deviation of the S& 500 at 18%, and the annualized standard deviation of Argentina’s dollar-denominated government debt at 25%. In addition to the country risk premium, Kioko is concerned about whether Oswald will need to issue new capital to finance the project, and the impact that it may have on the firm’s cost of capital. Kioko wants to maintain the firm’s target capital structure of 70% equity and 30% debt. Currently, Oswald has slightly more than 70% equity as a result of $20 million in excess retained earnings that Kioko plans to use for the project. If any new capital needs to be raised, Kioko estimates that the marginal cost of debt will increase if the firm needs more than $100 million in new equity capital. After conducting her analysis, Kioko makes the following statements to her supervisor.

Statement 1: The country risk premium we should add to the cost of equity to capture Argentina’s country risk is 10.40%.

Statement 2: If we have to raise new capital to take on the project, we should discount the cash flows at a higher cost of capital, because the amount of capital needed exceeds our marginal cost of capital breakpoint of $150 million.

How should Kioko’s supervisor respond to her statements?

          Statement 1                                   Statement 2

A)    Agree                                   Disagree

B)   Disagree                               Disagree

C)   Disagree                               Agree

Correct answer is B)

Kioko’s first statement is incorrect and her supervisor should disagree. The country risk premium is calculated as:

CRP = Sovereign yield spread (Ann. STD of index ÷ Ann. STD of sovereign bond market)
CRP = (0.098 – 0.046)(0.36 ÷ 0.25) = 0.7488, or 7.49%. Note that the standard deviation of the S& 500 is extra information that is not used for the calculation.

Kioko’s second statement is incorrect and her supervisor should also disagree. Although she is correct that a higher marginal cost of capital rate should be used, she is incorrect about the value of the breakpoint. The breakpoint is calculated as:

Breakpoint = (Amount of capital where source cost changes ÷ Proportion of capital from source)
Breakpoint = ($100 million ÷ 0.70) = $142.86 million.

Q2. In order to more accurately estimate the cost of equity for a company situated in a developing market, an analyst should:

A)   use the yield on the sovereign debt of the developing country instead of the risk free rate when using the capital asset pricing model (CAPM).

B)   add a country risk premium to the risk-free rate when using the capital asset pricing model (CAPM).

C)   add a country risk premium to the market risk premium when using the capital asset pricing model (CAPM).

Correct answer is C)

In order to reflect the increased risk when investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM.

iii

thanks

Please let me see the answer, I am vary appricated u .