Pretty Face is an American company that produces body care products. Founded in 1948, the company has grown from a small family business to a medium-sized corporation (around 400 employees), with more than 50 stores spread all over the United States. The company is contemplating establishing a subsidiary in Brazil, the first step in becoming a leading brand in South America. The subsidiary will initially operate for a period of five years, with a decision by Pretty Face of whether or not to carry on with the foreign business to be made later on during the project's lifetime. Pretty Face's required rate of return is 8%, and the development of the subsidiary requires an initial investment of BRL$60 million (BRL - Brazilian real - is the country's currency): 60% is to be allocated to the construction of facilities, 30% to the purchase of machines, and 10% to working capital. At this stage, the only product to be marketed in Brazil will be Pretty Face's flagship brand Sunnies, a sunscreen that the company expects to sell at a price of BRL$18 per unit (i.e. to be adjusted annually as per the inflation rate, forecasted at 6% per year), with an estimated demand of 1,400,000 units per year (i.e. assumed to be stable during the project's lifetime). The variable costs associated with the production of the sunscreen are mainly due to labour and materials, amounting to BRL$8 per unit, with fixed costs being mainly overhead expenses of BRL$2,000,000 per year. The only factor causing future changes in both variable and fixed costs is the inflation rate. Tax laws in Brazil allow for the total cost of facilities and machines to be fully depreciated (i.e. zero book value) by the end of year 5, in amounts equally spread across the project's lifetime. Although the machines to be employed in the production of the sunscreen will have zero salvage value, at the end of the project the facilities built could be sold at an estimated price of BRL$43.2 million (i.e. the commercial real estate sector is booming in Brazil, with no signs 9017IBF SUBJECT OUTLINE Australian Institute of Business Term 2 2019 7 of waning in the foreseeable future). Although Brazil imposes a corporate tax rate of 25% on income, there are neither capital gain taxes nor restrictions or taxes on funds to be sent to Pretty Face in the United States.

Question: Pretty Face would like to issue new shares to finance the investment in the Brazilian subsidiary. Based on the capital asset pricing model (CAPM), provide an estimate of what the cost of equity would be if shares were issued in United States, and similarly if shares were issued in Brazil. Elaborate on the factors driving the difference between the two.