Past Papers - Examiner's Solutions December 2007 Question 1 Suntona plc is a UK specialist retailer and is considering a project in the US. There is no similar US company to Suntona. Suntona has an asset beta of 1.10, and a debt beta of 0.25. The stock market risk premium is 6% in both the UK and the US. Suntona’s target debt-equity ratio is 40:60. The company’s pre-tax cost of debt is 6.00%. The UK has a one year risk free rate of 4.50% – it is 2.75% in the US – and the term structure of interest rates is flat in both countries over the next five years. Suntona’s tax rate is 30% (assume US tax rate also 30%). Required: a. What is the required rate of return (WACC%) on the project denominated in US dollars? (7 marks) b. Explain the two methods by which foreign projects can be evaluated. (5 marks) c. The spot rate is $1.90/£1. Calculate the forward rates for the next five years. (4 marks) d. The company has estimated that the project incremental cash flows (FCF*) for the next five years are $30m, $40m, $60m, $70m, and $30m, respectively. The initial outlay for the project is $135m. What is the NPV? (6 marks) e. Where do very good projects come from and why is it so hard to find and maintain them? (8 marks) Case Solution 1 (a) What is the required rate of return (WACC%) on the project denominated in US dollars? (7 marks) Cost of capital calculation Weighted beta Asset beta Debt beta Equity beta 1.1 0.25 1.6667 risk free rate mkt risk prem re = rd = 0.045 0.06 0.145 0.06 cost of equity cost of debt tax rate equity weight debt weight 0.145 0.06 0.30 0.600 0.400 0.1 1 1.1 Weighted cost After tax 0.0870 0.0168 0.1038 0.1038 UK cost of capital 10.38% US cost of capital 0.0853 8.53% Finance Edinburgh Business School 1 Past Papers - Examiner's Solutions / December 2007 The calculation: 1.0853 1 UK cost of cap interest rate differential 1.1038 0.9833 1.0853 (b) Explain the two methods by which foreign projects can be evaluated. (5 marks) Method 1 – take the