Question

2. LATAM is Latin America's biggest airline, headquartered in Chile. The company has approached you for advice on hurdle rates in its three biggest regions: Chile, Brazil and US. You have been given the following information on the three countries: 10-year Govt Bond rate in US $ 4.00% 5.00% 3.00% 10-yr Govt Bond rate in local currency 6.25% (CP) 12.00% ($R) 3.00% Standard deviation in local equity index 24% 28% 20% Standard deviation on 10-year Govt Bond 16% 20% 15% | Chile L Brazil USD Assume that the levered) beta for LATAM is 1.10 and that the equity risk premium for a mature market (US) is 5.00%. You can also assume that Chile and Brazil have local currency ratings that match their foreign currency ratings. a. Estimate the US dollar cost of equity for LATAM's Brazilian operations. (1.5 points) b. Estimate the Chilean Peso cost of equity for LATAM's Chilean operations. (2 points)

Answer 1

a). risk-free rate = US govt 10-year bond rate of 3%

Beta = 1.10

Equity risk premium (ERP) = US risk premium + additional risk premium for Brazil

Additional risk premium for Brazil = (default spread over US$ bond)*standard deviation in Brazil equity index/standard deviation on 10-year Brazilian govt bond = (5% - 3%)*(28%/20%) = 2.80%

ERP = 5% + 2.80% = 7.80%

US $ cost of equity for Brazilian operations = risk-free rate + beta*ERP = 3% + 1.10*7.80% = 11.58%

b). risk-free rate = 10-ys Chilean bond rate - default spread over US$ bond = 6.25% - (4%-3%) = 5.25%

Beta = 1.10

ERP = US risk premium + additional risk premium for Chile

= 5% + (4%-3%)*(24%/16%) = 6.50%

Chilean peso cost of equity = 5.25% + 1.10*6.50% = 12.40%