Question 18.12: The British MNC’s equity shares have a beta of 1.5, the Brit......
The British MNC’s equity shares have a beta of 1.5, the British Treasury bonds yield a rate of return of 5 per cent and the return on the market portfolio is 11 per cent. Compute the cost of equity capital of the British multinational.
\qquad \qquad K_e = 5%* + 1.5 (11% – 5%) = 14 per cent
*Return on British Treasury bonds is a proxy of risk-free rate of return.
\, The value of beta of 1.5 means that the equity shares of the British multinational is more risky than the average market portfolio. Hence, the required rate of return expected by an equity investor is higher or the cost of equity is higher. It will obviously decrease with decrease in the value of beta. Assume, b is 0.9; k_e is lower at 10.4 per cent, i.e., 5% + 0.9 (11% – 5%) = 10.4 per cent. The reason is that the equity securities of the British multinational are less risky than those of the market portfolio.
\, It is significant to note that foreign companies/MNCs, in general, may have a lower k_e than domestic companies due to the fact that they have access to several foreign capital markets to raise funds.