5. Cross-border Dimensions to Capital Budgeting

A New Zealand firm, Geyser Ltd is considering setting up a project in Volcanoland (whose currency is the Volcanic peso). The following information applies:

• Volcanolands bonds trade at a default spread of 3.5% over the NZ government bond rate of 2%.

• The Volcanoland equity market has an average volatility of 0.9 while the volatility of its long-term bond market is 0.5.

• The relevant beta for Geyser Ltd in New Zealand is 1.8 and the tax rate for the company in NZ is 28% while it is 39% in Volcanoland. Please assume that no debt beta is necessary.

• The market risk premium in NZ is 6.5%.

• Geyser Ltd intends to borrow in Volcanoland at a local rate of 12% (in Volcanic pesos) and maintain a debt ratio of 40% for Volcanoland projects in line with its debt ratio of 45% in NZ.

• The inflation rate is 3% in NZ and 12% in Volcanoland.

Required:

(a) Estimate the cost of equity in NZ dollar terms for Geysers possible Volcanoland project.

( 8 marks)

1. Estimate the cost of capital (WACC) in NZ dollar terms for Geysers possible Volcanoland project.

( 4 marks)

2. Estimate the cost of equity in Volcanic peso terms for the Volcanoland project.

( 2 marks)

3. Estimate the WACC in Volcanic peso terms for the Volcanoland project.

( 2 marks)

4. Explain what would happen to the WACC and the NPV of the project in Volcanoland if Volcanolands inflation rate were to unexpectedly increase. Why would these things happen? [Note: No marks will be given for the trivial solution because inflation increases.]

( 4 marks)

TOTAL: 20 MARKS