Everhart, Inc., is a U.S. firm with no international business. It issues debt in the United States at an interest rate of 10 percent per year. The risk-free rate in the United States is 8 percent. The stock market return in the United States is expected to be 14 percent annually. Everhart’s beta is 1.2. Its target capital structure is 30 percent debt and 70 percent equity. Everhart is subject to a 25 percent corporate tax rate. Everhart plans a project in the Philippines in which it would receive net cash flows in Philippine pesos on an annual basis. The risk of the project would be similar to the risk of its other businesses. The existing risk-free rate in the Philippines is 21 percent and the stock market return there is expected to be 28 percent annually. Everhart plans to finance this project with either its existing equity or by borrowing Philippine pesos.
a. Estimate the cost to Everhart if it uses dollar-denominated equity. Show your work.
b. Assume that Everhart believes that the Philippine peso will appreciate substantially each year against the dollar. Do you think it should finance this project with its dollar-denominated equity or by borrowing Philippine pesos? Explain.
c. Assume that Everhart receives an offer from a Philippine investor who is willing to provide equity financing in Philippine pesos to Everhart. Do you think this form of financing would be more preferable to Everhart than financing with debt denominated in Philippine pesos? Explain.
a. Based on the CAPM, Everhart’s cost of equity = 8% + 1.2 (14% – 8%) = 15.2%.
b. Philippine debt has high interest rate. Also, the peso will appreciate so the debt is even more expensive. Everhart should finance with dollar-denominated debt.
c. Philippine debt is cheaper than Philippine equity. The Philippine investor would require a higher return than if Everhart uses debt. Also, there is no tax advantage if Everhart accepted an equity investment.