Question

the US Treasury bond rate is 5.5% (in other words r_M – r_RF in the SML equation). Also please assume there are no debt betas.

A US-based utility is considering locating it in the (mythical) country of Shan.

• The Shan government has issued 10-year government bonds with a YTM of 21%, while in the US, the Treasury bond rate (on 10-year bonds) is 7%.
• The volatility of equity in Shan is 40% in annual terms while the volatility of long-term debt is 32%
• Standard and Poors gives Shan a “D” rating, which currently implies a credit spread of 14%
• The firm could raise 10-year debt at an after tax rate of 24% in Shan.
• The project is financed with 60% debt and 40% equity
• Assume that the appropriate levered beta for power plants with this debt ratio, irrespective of country, is 0.8
• Operating costs as a percentage of sales in Shan are equivalent to the operating cost percentage found for power plants in both Shan and in the US.

(a)      Determine the equity risk premium which should be applied to the cost of equity of the project in Shan.

(b)      What is the cost of equity for this project, if it is located in Shan?

(c)      What is the cost of capital for this project, if it is located in Shan?

Answer 1

a). Total risk premium for the project = market risk premium + country risk premium.

Market risk premium is already provided as 5.5%.

Country risk premium = volatility of equity market in Shan wrt bond market* default spread on Shan bond rating

= (40%/32%)*14% = 17.50%

Total risk premium = 5.5% + 17.50% = 23%

b). Cost of equity in Shan = risk-free rate + beta*total risk premium

= 21% + (0.8*23%) = 39.40%

c). After-tax cost of debt = 24%

Debt ratio = 60%; equity ratio = 40%

Cost of capital = (debt ratio*cost of debt) + (equity ratio*cost of equity)

= (60%*24%) + (40%*39.40%) = 30.16%

c).