Description
A Case study and few questions
Case Study on KS and Cost of capital
• Lexon company, 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 = 6% • Argentina risk free rate = 10% • Risk premium on dollar denominated debt provided by US creditors = 3% • Risk premium on Argentine peso denominated debt provided by Argentine creditors = 5% • Beta of project ( expected sensitivity of project returns to US investors in response to the US market ) = 1.5 % • Expected US market return = 14% • US Corporate tax rate = 30% • Argentine tax rate = 30% • Creditors will likely allow no more than 50 % of the financing to be in the form of debt, which implies that equity must provide at least half of the financing.
1. Calculate Lexon’s cost of each component of Capital – i.e. calculate cost of dollar denominated debt, Cost of Argentine peso denominated debt, and cost of dollar denominated equity. 2. Calculate Lexon’s estimated weighted average cost of capital WACC) for financing a project under 4 possible capital structure – a) 50% US debt and 50% US Equity b) 20% US debt, 50% US Equity, 30% Argentine debt, c) 50% Argentine debt, 50 % US Equity, d) 30% US debt and 70% US Equity. Comment on your results.
Lexon’s Project with different financing arrangements
• Reconsider Lexon Co which might finance the Argentine project with partial financing from Argentina. Assume Lexon would need to invest additional 80 million pesos (AP). Current ER = $.50 (i.e. $ 40 m are needed). Lexon will use equity for 50% of the funds i.e. 20 million. For the remaining, Lexon will either borrow dollars and convert into pesos or borrow pesos. The project will be terminated in 1 year, at that time the debt will be repaid and any earnings generated by the project will be remitted to the Lexon parent in US. Revenues from the project are – AP 200 million and OE in Argentina are AP 10 million. Lexon expects that Argentine peso will be valued at $.40 in one year. The project will not generate any revenue in US but Lexon expects to incur $ 10 million in US. It will also incur dollar denominated interest expense if it finances the project with dollar denominated debt. Any dollar denominated expenses provide tax benefits, as the expenses will reduce US taxable income from other operations. The amount of debt used in each country affects the interest payments incurred and the taxes paid in that country.
• Calculate the NPV for Lexon based on two financing alternatives • 1. Rely on US Debt – $ 20 million borrowed and equity of $ 20 million
• 2. Rely on Argentine debt - 40 million Pesos borrowed and equity of $ 20 million Assume cash flows to the parent are discounted at the parent’s cost of equity i.e. 18% which represents the required rate of return on the project by the parent’s shareholders.
doc_303598493.ppt
A Case study and few questions
Case Study on KS and Cost of capital
• Lexon company, 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 = 6% • Argentina risk free rate = 10% • Risk premium on dollar denominated debt provided by US creditors = 3% • Risk premium on Argentine peso denominated debt provided by Argentine creditors = 5% • Beta of project ( expected sensitivity of project returns to US investors in response to the US market ) = 1.5 % • Expected US market return = 14% • US Corporate tax rate = 30% • Argentine tax rate = 30% • Creditors will likely allow no more than 50 % of the financing to be in the form of debt, which implies that equity must provide at least half of the financing.
1. Calculate Lexon’s cost of each component of Capital – i.e. calculate cost of dollar denominated debt, Cost of Argentine peso denominated debt, and cost of dollar denominated equity. 2. Calculate Lexon’s estimated weighted average cost of capital WACC) for financing a project under 4 possible capital structure – a) 50% US debt and 50% US Equity b) 20% US debt, 50% US Equity, 30% Argentine debt, c) 50% Argentine debt, 50 % US Equity, d) 30% US debt and 70% US Equity. Comment on your results.
Lexon’s Project with different financing arrangements
• Reconsider Lexon Co which might finance the Argentine project with partial financing from Argentina. Assume Lexon would need to invest additional 80 million pesos (AP). Current ER = $.50 (i.e. $ 40 m are needed). Lexon will use equity for 50% of the funds i.e. 20 million. For the remaining, Lexon will either borrow dollars and convert into pesos or borrow pesos. The project will be terminated in 1 year, at that time the debt will be repaid and any earnings generated by the project will be remitted to the Lexon parent in US. Revenues from the project are – AP 200 million and OE in Argentina are AP 10 million. Lexon expects that Argentine peso will be valued at $.40 in one year. The project will not generate any revenue in US but Lexon expects to incur $ 10 million in US. It will also incur dollar denominated interest expense if it finances the project with dollar denominated debt. Any dollar denominated expenses provide tax benefits, as the expenses will reduce US taxable income from other operations. The amount of debt used in each country affects the interest payments incurred and the taxes paid in that country.
• Calculate the NPV for Lexon based on two financing alternatives • 1. Rely on US Debt – $ 20 million borrowed and equity of $ 20 million
• 2. Rely on Argentine debt - 40 million Pesos borrowed and equity of $ 20 million Assume cash flows to the parent are discounted at the parent’s cost of equity i.e. 18% which represents the required rate of return on the project by the parent’s shareholders.
doc_303598493.ppt