3. Travers Inc. is a globally diverse MNE that operates in many integrated forei

Question

3. Travers Inc. is a globally diverse MNE that operates in many integrated foreign markets. The firm estimates its cost of common equity using the CAPM approach. An analyst is estimating the cost of common equity for one of Travers’ foreign subsidiaries. With respect to a domestic market index (in the host country) that has an equity risk premium of 7 percent, Travers has a beta of 1.4. With respect to a world market index that has an equity risk premium of 5 percent, Travers has a beta of 1.1. If the appropriate risk-free rate for all CAPM calculations is the U.S. Treasury rate of 4 percent, how large an error would the analyst make if she used the wrong version of the CAPM?

a.   3.8%

b.   3.9%

c.   4.2%

d.   4.4%

e.   4.7%

Explanation / Answer

Cost of equity( using domestic market index data)

Ke=Rf+ Equity risk premium × Beta

Ke= 4+ 7×1.4

Ke= 13.80%

Cost of Equity ( world market index data)

Ke= Rf+Equity risk premium ×beta

Ke= 4+ 5×1.1

Ke= 9.50%

Error by using wrong version of CAPM:

13.80-9.5.= 4.3% or 4.4% appx.

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