Cost of Capital and Risk of Foreign Financing Nevada Co. is a U.S. firm that conducts major importing and exporting business in Japan, with all of these transactions invoiced in dollars. It obtained debt in the United States at an interest rate of 10 percent per year. The long-term risk-free rate in the United States is 8 percent. The stock market return in the United States is expected to be 14 percent annually. Nevada’s beta is 1.2. Its target capital structure is 30 percent debt and 70 percent equity. The firm is subject to a 25 percent corporate tax rate (federal and state combined). Estimate the cost of capital to Nevada Co. Nevada has no subsidiaries in foreign countries but plans to replace some of its dollar- denominated debt with Japanese yen-denominated debt because Japanese interest rates are low. It will obtain yendenominated debt at an interest rate of 5 percent. It cannot effectively hedge the exchange rate risk resulting from this debt because of parity conditions that make the price of derivatives contracts reflect the interest rate differential. How could Nevada Co. reduce its exposure to the exchange rate risk resulting from the yen-denominated debt without moving its operations?

FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698
FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698

Solutions

Chapter 17, Problem 26QA
Textbook Problem

Cost of Capital and Risk of Foreign Financing Nevada Co. is a U.S. firm that conducts major importing and exporting business in Japan, with all of these transactions invoiced in dollars. It obtained debt in the United States at an interest rate of 10 percent per year. The long-term risk-free rate in the United States is 8 percent. The stock market return in the United States is expected to be 14 percent annually. Nevada’s beta is 1.2. Its target capital structure is 30 percent debt and 70 percent equity. The firm is subject to a 25 percent corporate tax rate (federal and state combined).

  1. Estimate the cost of capital to Nevada Co.
  2. Nevada has no subsidiaries in foreign countries but plans to replace some of its dollar-

denominated debt with Japanese yen-denominated debt because Japanese interest rates are low. It will obtain yendenominated debt at an interest rate of 5 percent. It cannot effectively hedge the exchange rate risk resulting from this debt because of parity conditions that make the price of derivatives contracts reflect the interest rate differential. How could Nevada Co. reduce its exposure to the exchange rate risk resulting from the yen-denominated debt without moving its operations?

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