Bidder Ltd, a U.S.-based corporation, wants to purchase

Bidder Ltd, a U.S.-based corporation, wants to purchase Tara Corp. Bidder’s management believes that the country in which Tara is located is segmented from global capital markets.

Assumptions:

  • The current U.S. Treasury bond rate is 2%.
  • The expected inflation rate in Tara’s country is 5% annually, as compared to 2.0% in the U.S.
  • The country risk premium (CRP) for Tara’s country provided by S&P is estimated to be 1.5%.
  • Based on Tara’s interest coverage ratio, its credit rating is estimated to be AA. The current interest rate on AA-rated US corporate bonds is 3.0%.
  • Since its marginal tax rate is higher than Tara’s, Bidder’s marginal tax rate of 35% is used in calculating WACC.
  • Bidder’s pretax cost of debt is 4%. The firm’s total capitalization consists only of common equity and debt. Bidder’s projected debt-to-total capital ratio is 0.4.
  • Tara’s beta and the country beta are estimated to be 1.8 and 0.6, respectively.
  • The equity premium is estimated to be 5% based on the spread between the prospective return on the country’s equity index and the estimated risk-free rate of return.
  • Given Tara Inc.’s current market capitalization of $2 billion, the firm’s size premium (FSP) is estimated at 1.5.

What is the appropriate weighted average cost of capital (WACC) Bidder Ltd should use to discount Tara’s projected annual local currency cash flows? (8 marks)