Question

7. Suppose a U.S. firm is considering whether to issue stock in the U.S. or in Mexico. Assume the two stock markets are fully segmented, and that the following conditions prevail: Mexico U.S. Stock market expected return 8% 7% firm’s beta 0.8 1.0 riskless rate 3% 1% Expected rate of peso appreciation -2%/year against the U.S. dollar

a) What is the cost of equity issued in the U.S.?

b) What is the cost of issuing equity in Mexico, from the U.S. corporation’s perspective? Your answer should again be in percent per year, and should recognize that the dollar is the home currency for the U.S. corporation.

Answer 1

a). Solution :- Cost of equity (in U.S.) = Risk free rate + Beta * (Market return - Risk free rate).

= 1 % + 1.0 * (7 % - 1 %)

= 1 % + 1.0 * 6%

= 1 % + 6 %

= 7 %

Conclusion :- Cost of equity (in U.S.) = 7 %.

b). Solution :- Cost of equity (in Mexico) = Risk free rate + Beta * (Market return - Risk free rate).

= 3 % + 0.8 * (8 % - 3 %)

= 3 % + 0.8 * 5 %

= 3 % + 4 %

= 7 % (Before considering currency appreciation as compared to US dollar)

From U.S. corporation view, Cost of equity in Mexico (after adjusting for currency appreciation) = 7 % - 2 % of 7 %

= 7 % - 0.14 %

= 6.86 %

Conclusion :- Cost of equity in Mexico (from U.S. corporation view) = 6.86 % (approx).