Modern Media, an all-equity funded US entertainment company, is planning an acquisition of an Mexican entertainment firm for $500 million (entirely financed with equity). The average unlevered beta across entertainment companies is 1.05. The expected cash flows for the target company have been estimated in nominal pesos and you have been asked for some advice on the inputs to use to estimate the cost of equity to discount these cash flows.

a) The Mexican government has 10-year U.S. dollar denominated bonds, trading at 5.25%, and 10-year nominal peso denominated bonds, trading at 7.25%, and both are rated AA by S&P. The ten-year U.S. T. bond rate is 4%. What risk free rate would you use to estimate the cost of equity?