question archive Recall Blades Inc
Recall Blades Inc
Subject:FinancePrice:4.87 Bought7
Recall Blades Inc. that is a famous producer of Speedos and has tentatively decided to establish a subsidiary in Thailand to manufacture roller blades. The new plant will be operated for 10 years and expected to be sold after that. Furthermore, forecasts for the future value of the THB indicate that the currency may continue to depreciate in the future.
At a recent meeting of the board of directors, the CFO of the company Mr. Holt presented his capital budgeting analysis. The CFO demonstrated the establishment of a subsidiary in Thailand had a net present value (NPV) of about $8 million with a 25 percent required rate of return.
Blades' board of directors, while favorable to the idea of international expansion, remained skeptical and had some questions about the changes that Thailand will face after it establishes a subsidiary in Thailand. They want to know the possible changes that might occur in the investors' required rate of return, cost of capital, systematic risk, cost of debt and equity, and capital structure of the company after Blades inc establishes a subsidiary in Thailand.
Therefore, Mr. Holt, the CFO of Blades Inc. has asked you as the financial analyst for the company to write a paper that studies thoroughly the concerns of the board of directors. Your paper should include the thorough analysis of the CAPM model, the mathematical formulation for the concepts you explain, and the numerical calculation by using the information given to you in the assignment and by using the internet.
Data for Calculation of WACC that you could incorporate in your paper provided in the following table 3:
Table 3
Hypothetical Data Information for calculation of WACC
Text
USA
Thailand
Risk free Rate
2.5%
6.5%
Market Risk Premium
12%
18%
Borrowing Rate for the Company
8%
15%
Corporate Tax Rate (average)
21%
15%
Debt to Total Asset Ratio *
55%
42%
Equity Beta
1.8
2.4
* Debt to Asset Ratio is the percentage of capital borrowed from the local financial institutions.
Please note that in many developing countries the limit on Debt to Asset is less than the limit set in developed countries due to higher business risk involved.
Additionally, after establishing a subsidiary in Thailand 10% of the company's total capital will be allocated to a Thailand subsidiary. In order to avoid the effect of the exchange rate movement on WACC calculations the company enters in a one-year forward contract which ensures converting THB back to USD at the end of the fiscal year will be the same as the rate at the beginning of the same fiscal year. The cost of entering forward contact of the expected cash flow back to the US at the end of the fiscal year assumed as 5%, which will increase the WACC by some percent.
- Calculate the company's Weighted Average Cost of Capital (WACC) before and after expansion to Thailand.
- Explain, what are the main reasons for the change in the company's WACC after expansion to Thailand.
- Provide your recommendation on how the company can reduce the WACC after expansion to Thailand.
- Given the high level of interest rates in Thailand, the high level of exchange rate risk, and the high (perceived) level of country risk, do you think Blades will be more or less likely to use debt in its capital structure as a result of its expansion into Thailand? Why
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Answer:
1)
WACC before is 14.321%
WACC after is 39.18%
2)
- The market risk results in higher beta for the firm that which increased the capital cost
- The higher cost of borrowing as compared to the US
- Low tax rate results to the low tax shield
- Cost of mitigating exchange risk
3)
- The company can reduce the WACC after expansion to Thailand by the following method:
- Borrowing from the US and using Malaysia funds instead of borrowing from Malaysia.
- Taking advantage of the tax shield of the US instead of Malaysia.
4)
No, Blades is not likely to use debt to finance the project since debt always has a hidden bankruptcy risk, which may be detrimental for the firm.
Step-by-step explanation
a)
WACC) before expansion to Thailand:
In the US
R = Rf + beta*Market Premium = 2.5% + 1.8*12% = 24.1%
After tax debt cost = 8%*(1-21%) = 6.32%
WACC = Wd*Rd + WeRe = 0.55*6.32% + 0.45*24.1% = 14.321%
After expansion,
WACC in Malaysia,
R = Rf + beta*Market Premium = 6.5% + 2.4*18% = 49.7%
After tax debt cost = 15%*(1-15%) = 12.75%
WACC = Wd*Rd + WeRe = 0.42*12.75% + 0.58*49.7% = 34.18%
Increase in WACC as aresult of exchange cost = 5%
WACC = 39.18%
New WACC = 90%*14.321% + 10%*39.18% = 16.81%
Thus, WACC increased from 14.321% to 16.81%
2)
- The market risk results in higher beta for the firm that which increased the capital cost
- The higher cost of borrowing as compared to the US
- Low tax rate results to the low tax shield
- Cost of mitigating exchange risk
3)
The company can reduce the WACC after expansion to Thailand by the following method:
- Borrowing from the US and using Malaysia funds instead of borrowing from Malaysia.
- Taking advantage of the tax shield of the US instead of Malaysia.
4)
No, Blades is not likely to use debt to finance the project since debt always has a hidden bankruptcy risk, which may be detrimental for the firm. As such, the firm is most likely to use equity, although it carries a high cost of equity.
