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

• Volcanoland’s 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:

Estimate the cost of equity in NZ dollar terms for Geyser’s possible Volcanoland project.

Estimate the cost of capital (WACC) in NZ dollar terms for Geyser’s possible Volcanoland project.

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

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

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

Answer rating: 100% (QA)

1 cost of value Rf betaRm Rf 2 18 652 1010 2 WACC ... View the full answer