Make a reasonable estimate of the required return, starting with a 12% weighted

Question

Make a reasonable estimate of the required return, starting with a 12% weighted average cost of capital for the U.S. auto manufacturer, and adding reasonable estimated percentages for each of the separate risk elements you can foresee.

To make it easier for all of you to address this question efficiently, I have made a template which each of you can fill in with the risks that you see and which you can then quantify. Our discussion can then revolve around the issue of how risky each of the elements each of you identify actually are. For example, someone might inaccurately state that ten percentage points should be added to the WACC to adjust for foreign exchange rate risk and give his or her reasons for adding such a high risk premium. Others will likely disagree with that assessment, giving their reasons, and that will give us material for a very lively discussion.

I have written a few risks into the template below. Please add your own and estimate how many percentage points should be added to reflect the higher risk in China. Explain your reasoning.

Required Rate of Return

Estimate

Company domestic WCC

12%

Economic and Legal Risk

Foreign Exchange risk

Government & Political risk

Estimated Required Rate of Return=

Required Rate of Return

Estimate

Company domestic WCC

12%

Economic and Legal Risk

Foreign Exchange risk

Government & Political risk

Estimated Required Rate of Return=

Explanation / Answer

Economic and Legal Risk: China has world’s fastest growing economy. It has always encouraged manufacturing sector. Looking at china’s stable economy legally sound procedure I would only charge a 1% risk premium for economic and legal risk.

Foreign exchange risk: China exports most of its manufactured electronic goods are exported. Since this US auto manufacturer has to deal in Chinese market and export goods to them, and due to foreign currency interchange, I see a great amount of foreign exchange risk. Therefore, I am assigning 5% risk premium for foreign exchange risk.

Government and political risk: In china, companies work in relatively uncertain political environment which increase the political risk. However, the Chinese government has been supportive from last 25 years to increase international business. Therefore, I am assigning 2.5% risk premium to this risk.

Domestic wacc

12%

Economic and legal risk

1%

Foreign exchange risk

5%

Govt and political risk

2.50%

Estimated required rate of return

20.50%

Domestic wacc

12%

Economic and legal risk

1%

Foreign exchange risk

5%

Govt and political risk

2.50%

Estimated required rate of return

20.50%

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