3. A U.S. based MNC has the following two sets of information, one for its domes

Question

3. A U.S. based MNC has the following two sets of information, one for its domestic operations and one for its global operations: Domestic: Standard deviation of the company's return = 18% pa. Covariance of the company's return with the U.S. stock market returns = 270 Global: Standard deviation of the company's return = 24% pa Covariance of the company's return with the global stock market returns = 144 In addition, the following market information is available: US. stock market risk premium = 12% pa. Standard deviation of the U.S. stock market = 20% pa. The risk-free rate in the US. = 3% pa Expected return on the global stock market = 20% pa. Standard deviation of the global stock market-30% pa. Show whether the cost of equity for domestic operations is higher or lower than that of global operations. Analyze on all levels and explain the difference in the two costs?

Explanation / Answer

Beta for domestic operations = (Covariance of company's stock market returns with US stock market returns)/(Variance of US stock market returns)

= 270/SD^2 = 270/20^2 = 270/400 = 0.675

Beta for Global Operations = 144/30^2 = 144/900 = 0.16

Cost of equity for domestic operations = Rf + Beta * MRP = 3% + 0.675*12% = 11.1%

Cost of Equity for Global operations = 3% + 0.16*(20%-3%) = 5.71%

As Beta is measure of systematic risk ie market risk , we find that the company is not correlated much with the global market change and hence the risks are low(systematic). Unsystematic risks are eliminated using diversification in global markets and hence need not figure in the cost of equity.

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