Question

GE wants to do an investment in Brazil. The equity investment is BRL 100M and Debt issue is BRL 150 M. The analyst finds that Brazilian tax rate is 35% and the risk free rate is 7.4%. GE can borrow in Brazil at 60 bps over the Brazilian Treasuries. Similar projects in Brazil have a beta of 1.1. The return of the Brazilian market (BOVESPA) in the past 10 years is 12%. What would be the project’s cost of capital?

Answer 1

Equity investment:

Market value of equity, MV(Equity) = BRL 100m

• risk-free rate = 7.4%
• Return on BOVESPA market, Rm = 12%
• beta of the project = 1.1
• cost of equity using CAPM, Re = Rf + beta * (Rm - Rf)
• Re = 7.4% + [ 1.1 * (12% - 7.4%)
• Re = 7.4% + [ 1.1 * 4.60% ]
• Re = 7.4% + 5.06% = 12.46%

Debt Investment:

Market value of debt, MV(Debt) = 150m

tax rate = 35%

Borrowing rate, cost of debt, Rd= 60bps over Brazilian treasuries = 60bps + 7.40% = 0.60% + 7.40% = 8%

Cost of Capital:

wacc = WtE * Re + WtD * (1-tax) * Rd

• Equity = 100m
• Debt = 150m
• Capital = Debt + Equity = 100m + 150m = 250m
• WtE = 100m / 250m = 0.40
• WtD = 150m/250m = 0.60
• wacc = 0.40 * 12.46% + 0.06 * ( 1 - 0.35) * 8% = 0.04984 + 0.0312 = 0.08104 = 8.104%

cost of capital = 8.104% (answer)