A) Indigo is the largest and most successful specialty goods company based in De
ID: 2749950 • Letter: A
Question
A) Indigo is the largest and most successful specialty goods company based in Detroit, USA. It has not entered the Indian marketplace yet, but is considering establishing both manufacturing and distribution facilities in India through a wholly owned subsidiary. It has approached two different investment banking advisors, BOA and BOI, for estimates of what its costs of capital would be several years into the future when it planned to list its Indian subsidiary on an Indian stock exchange. Using the following assumptions by the two different advisors, calculate the prospective costs of debt, equity, and the WACC for Indigo (India):
BOA
BOI
Risk-free rate of interest
3.0%
3.0%
Estimate of Indigo’s cost of debt in Indian market
7.5%
7.8%
Estimate of market return, forward-looking
9.0%
12.0%
Corporate tax rate
35.0%
35.0%
Proportion of debt
35%
40%
Proportion of equity
65%
60%
Estimated Beta
1.2
1.16
b) Due to limited returns history of india’s equity market, Indigo‘s risk manager wants to adjust (kM – kf)Brazil . She wants to use U.S. market as the benchmark. Her research finds that market risk premium i.e. (km – krf)US is 5.00%. The standard deviation of returns on US equity US is 15.0% and that of India india is 25.0% . The standard deviation in the bond return for India India,bond is 20.1% . She also estimated country risk premium for India CRIndia is 3.00%. The expected interest rate in India is 3% and in US is 2%. Using the Mixed approach estimate the market risk premium in Indian Rupee terms, cost of equity and re-calculate WACC using new estimates.
BOA
BOI
Risk-free rate of interest
3.0%
3.0%
Estimate of Indigo’s cost of debt in Indian market
7.5%
7.8%
Estimate of market return, forward-looking
9.0%
12.0%
Corporate tax rate
35.0%
35.0%
Proportion of debt
35%
40%
Proportion of equity
65%
60%
Estimated Beta
1.2
1.16
Explanation / Answer
(A) Calculation of WACC for Indigo
Ke = Rf + Market risk premium x beta
For BOA
Ke = 3% + 9x1.20
= 13.80%
Kd = 7.50%(1-0.35)
= 4.875%
WACC = 4.875 x 0.35 + 13.80% x 0.65
= 10.67625%
For BOI
Ke = 3% + 12x1.16
= 16.92%
Kd = 7.80%(1-0.35)
= 5.07%
WACC = 5.07x0.40 + 16.92%x0.60
= 12.18%
(B)
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