Question

Genedak-Hogan is an American conglomerate that is actively debating the impacts of international diversification of its...

Genedak-Hogan 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 are 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 3.0​% risk premium for​ "going international" to the basic CAPM cost of equity.

Assumptions

Before

Diversification

After

Diversification

Correlation between​ G-H and the market

0.88

0.76

Standard deviation of​ G-H's returns

28.0​%

26.0​%

Standard deviation of​ market's returns

18.0​%

18.0​%

​ Risk-free rate of interest

3.0​%

3.0​%

Additional equity risk premium for internationalization

​0.0%

3.0​%

Estimate of​ G-H's cost of debt in U.S. market

7.2​%

7.0​%

Market risk premium

5.5​%

5.5​%

Corporate tax rate

35​%

35​%

Proportion of debt

38​%

32​%

Proportion of equity

62​%

68​%

1. What is​ Genedak-Hogan's cost of equity before international diversification of its operations without the hypothetical additional risk​ premium?

2. What is​ Genedak-Hogan's cost of equity before international diversification of its operations with the hypothetical additional risk​ premium?

3. What is​ Genedak-Hogan's cost of equity after international diversification of its operations without the hypothetical additional risk​ premium?

4. What is​ Genedak-Hogan's cost of equity after international diversification of its operations with the hypothetical additional risk​ premium?

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Homework Answers

Answer #1
Formula Before diversifcation After diversification
Correlation (a) 0.88 0.76
StDev of G-H's returns 28% 26%
StDev of market's returns 18% 18%
(a*b/c) Beta (B)                          1.369                     1.098
Risk-free rate (rf) 3.0% 3.0%
Additional equity risk premium (Ra) 0.0% 3.0%
Market risk premium (rm) 5.50% 5.50%
rf + (beta*rm) Cost of equity (without additional risk premium) 10.53% 9.04%
rf + (beta*rm) + Ra Cost of equity (with additional risk premium) 10.53% 12.04%

1). Ke = 10.53%

2). Ke = 10.53%

3). Ke = 9.04%

4). Ke = 12.04%

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