Use the table below, to answer the problem. Genedak-Hogan (G-H) is an American conglomerate that is actively debating the impacts of international diversification of its operations on its capital structure and cost of capital. The firm is planning on reducing consolidated debt after diversification. Senior management at Genedak-Hogan is actively debating the implications of diversification on its cost of equity. All agree that the company's returns will be less correlated with the reference market return in the future, the financial advisors believe that the market will assess an additional 3.5% risk premium for "going international" to the basic CAPM cost of equity. Many MNEs have greater ability to control and reduce their effective tax rates when expanding international operations. Assume that Genedak-Hogan was able to reduce its consolidated effective tax rate from 38% to 33% after international diversification.

a. Calculate the weighted average cost of capital for Genedak-Hogan before and after international diversification of its operations.

b. Adding the hypothetical risk premium to the cost of equity (an added 3.5% to the cost of equity because of international diversification), what is the firm's WACC before and after international diversification?

c. If Genedak-Hogan was able to reduce its consolidated effective tax rate from 38% to 33%, what would be the impact on its WACC?

 

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Assumptions Correlation between G-H and the market Standard deviation of G-H's returns Standard deviation of market's returns Risk-free rate of interest Additional equity risk premium for internationalization Estimate of G-H's cost of debt in U.S. market Market risk premium Corporate tax rate Proportion of debt Proportion of equity Symbol Pjm %; om Krf RPM Kd km-Krf t DIV EIV Before Diversification 0.86 28.5% 18.9% 3.6% 0.0% 7.4% 5.6% 38% 39% 61% After Diversification 0.76 24.6% 18.9% 3.6% 3.5% 6.8% 5.6% 38% 33% 67% Assumptions Correlation between G-H and the market Standard deviation of G-H's returns Standard deviation of market's returns Risk-free rate of interest Additional equity risk premium for internationalization Estimate of G-H's cost of debt in U.S. market Market risk premium Corporate tax rate Proportion of debt Proportion of equity Symbol Pjm %; om Krf RPM Kd km-Krf t DIV EIV Before Diversification 0.86 28.5% 18.9% 3.6% 0.0% 7.4% 5.6% 38% 39% 61% After Diversification 0.76 24.6% 18.9% 3.6% 3.5% 6.8% 5.6% 38% 33% 67%

Answer rating: 100% (QA)

1 Before Diversification there is no added Risk premium to the firms cost of equity Calculation of cost of equity prediversification will involve calculating the firms beta with respect to the market ... View the full answer