Question

Wild Hockey (WH), a US based firm, is considering an investment in Canada to produce hockey equipment. WH plans to borrow 40% of the required funding needs from the Bank of Montreal at a 4.35% interest rate (denominated in Canadian dollars).

      In order to estimate the cost of capital, WH has identified a similar Canadian company as a proxy to identify risk characteristics: Rupert’s Hockey Supplies.

Project risk information:

Co-variance of Rupert’s stock and US Stock market = 0.60

Variance of the US stock market = 0.44

     

Expected average annual inflation rate:

United States:                                                       2.2%

Canada:                                                                 1.5%

Market Information:

Current exchange rate:                                         USD 0.7850 = CAD 1

Risk-free rate (US):                                              3.0%

Expected market risk premium (US):                  6.0%

Tax rate for WH                                                     21%

                  What is the cost of capital for this project?

Answer 1

Cost = Amount to be incurred for getting a better product or item.

Capital = Amount raised from various sources for investment in the business.Therefore, the various sources are equity shares,preference shares, debt (Loans,bonds,debentures etc.)

Here, the firm is considering an investment in canada, so, thereby analysing the cost and risk which is to be incurred while making the investment:

Ke = Cost of capital = Rf + B (Rm - Rf)

Rf = Risk free rate of return = 3.0%

B = Beta coeffiecient = Covariance / Variance = 0.60/0.44 = 1.36

Rm = Market Return = 6.0%

Therefore, Ke = 3.0% + 1.36(6.0 - 3.0)% = 7.08%

Market Inflation CAD = 1.5%

therefore, Cost of capital after market inflation = ( 7.08 * 1.5 ) = 10.62%