Your company is considering a direct investment project to produce computers in Thailand, for sale in the US market. This will be partially financed by US dollar debt, and partially financed by issuing stock in Thailand.
Your boss instructs you to conduct an NPV analysis by estimating cash flows in USD terms, and discounting at an appropriate rate. He states that the stock issuance in Thailand should be used to determine the marginal cost of equity for the firm.
After some thought, you come up with the following assumptions:
The project will cost USD200mn in Year 0, and have a terminal value of USD50mn in Year 10.
The project will begin production in Year 1. It will produce 30,000 computers yearly in Years 1-10, at an initial price of USD2,000 per computer in Year 1. The price will increase at the US inflation rate of 2% per year.
Costs are expected to be 30,000 Thai baht (THB) per computer in Year 1, and will increase at the Thai inflation rate of 7% per year.
The spot exchange rate in Year 1 is expected to be 30 THB per USD. The exchange rate will be determined by relative purchasing power parity after that.
The firm’s benchmark USD bond was issued at a yield of 6%. It currently trades at a yield of 7%.
The firm’s capital structure is 40% equity, 60% debt.
You believe that the CAPM is the correct way to estimate the cost of equity capital, using a local market index as a benchmark. The Thai risk-free rate is 8%, the expected return on the Thai market is 12%, and the beta you expect on your stock is 1.5.
You believe that the International Fisher Effect is a useful method for comparing the cost of capital across countries.
1. What is the cost of equity capital in THB terms? What is the cost of equity capital in USD terms? What is the weighted average cost of capital for the firm?
2. Given the assumptions above, should the firm proceed with this project? What is the project’s NPV?
3. Suppose the expected Thai inflation rate increased to 12% per year, but all of the other assumptions remained unchanged. What is the project’s NPV? Should the firm proceed with this project or not?