BLADES, INC. CASE
Assessment of Cost of Capital
Recall that Blades has tentatively decided to establish a subsidiary in Thailand to manufacture roller blades. The new plant will be utilized to produce Speedos, Blades' primary product. Once the subsidiary has been established in Thailand, it will be operated for 10 years, at which time it is expected to be sold. Ben Holt, Blades' chief financial officer, believes the growth potential in Thailand will be extremely high over the next few years. However, his optimism is not shared by most economic forecasters, who predict a slow recovery of the Thai economy, which has been very negatively affected by recent events in that country. Furthermore, forecasts for the future value of the baht indicate that the currency may continue to depreciate over the next few years. Despite the pessimistic forecasts, Holt believes Thailand is a good international target for Blades' products because of the high growth potential and lack of competitors in Thailand. At a recent meeting of the board of directors, Holt presented his capital budgeting analysis and pointed out that the establishment of a subsidiary in Thailand had a net present value (NPV) of over $8 million even when a 25 percent required rate of return is used to discount the cash flows resulting from the project. Blades' board of directors, while favorable to the idea of international expansion, remained skeptical. Specifically, the directors wondered where Holt obtained the 25 percent discount rate to conduct his capital budgeting analysis and whether this discount rate was high enough. Consequently, the decision to establish a subsidiary in Thailand has been delayed until the directors' meeting next month. The directors also asked Holt to determine how operating a subsidiary in Thailand would affect Blades' required rate of return and its cost of capital. The directors would like to know how Blades' characteristics would affect its cost of capital relative to roller blade manufacturers operating solely in the United States. Furthermore, the capital asset pricing model (CAPM) was mentioned by two directors, who would like to know how Blades' systematic risk would be affected by expanding into Thailand. Another issue that was raised is how the cost of debt and equity in Thailand differ from the corresponding costs in the United States and whether these differences would affect Blades' cost of capital. The last issue that was raised during the meeting was whether Blades' capital structure would be affected by expanding into Thailand. The directors have asked Holt to conduct a thorough analysis of these issues and report back to them at their next meeting. Holt's knowledge of cost of capital and capital structure decisions is somewhat limited, and he requires your help. You are a financial analyst for Blades, Inc. Holt has gathered some information regarding Blades' characteristics that distinguish it from roller blade manufacturers operating solely in the United States, its systematic risk, and the costs of debt and equity in Thailand, and he wants to know whether and how this information will affect Blades' cost of capital and its capital structure decision. Regarding Blades' characteristics, Holt has gathered information regarding Blades' size, its access to the Thai capital markets, its diversification benefits from a Thai expansion, its exposure to exchange rate risk, and its exposure to country risk. Although Blades' expansion into Thailand classifies the company as an MNC, Blades is still relatively small compared to other U.S. roller blade manufacturers. Also, Blades' expansion into Thailand will give it access to the capital and money markets there. However, negotiations with various commercial banks in Thailand indicate that Blades will have to borrow at interest rates of approximately 15 percent, versus 8 percent in the United States. Expanding into Thailand will diversify Blades' operations. As a result of this expansion, Blades would be subject to economic conditions in Thailand as well as in the United States. Holt sees this as a major advantage since Blades' cash flows would no longer be solely dependent on the U.S. economy. Consequently, he believes that Blades' probability of bankruptcy would be reduced. Nevertheless, if Blades establishes a subsidiary in Thailand, all of the subsidiary's earnings will be remitted back to the U.S. parent, which would create a high level of exchange rate risk. This is of particular concern because current economic forecasts for Thailand indicate that the baht will depreciate over the next few years. Furthermore, Holt has already conducted a country risk analysis for Thailand that resulted in an unfavorable country risk rating. Regarding Blades' level of systematic risk, Holt has determined how Blades' beta, which measures systematic risk, would be affected by the establishment of a subsidiary in Thailand. He believes that Blades' beta would drop from its current level of 2.0 to 1.8 because the firm's exposure to U.S. market conditions would be reduced by its expansion into Thailand. Moreover, Holt estimates that the risk-free interest rate is 5 percent and the required return on the market is 12 percent. Holt has also determined that the costs of both debt and equity are higher in Thailand than in the United States. Lenders such as commercial banks in Thailand require interest rates higher than U.S. rates. This is partially attributed to a higher risk premium, which reflects the larger degree of economic uncertainty in Thailand. The cost of equity is also higher in Thailand than in the United States. Thailand is not as developed as the United States in many ways, and various investment opportunities are available to Thai investors, which increases the opportunity cost. However, Holt is not sure that this higher cost of equity in Thailand would affect Blades, as all of Blades' shareholders are located in the United States. Holt has asked you to analyze this information and to determine how it may affect Blades' cost of capital and its capital structure.
To help you in your analysis, he would like you to provide answers to the following questions:
1. If Blades expands into Thailand, do you think its cost of capital will be higher or lower than the cost of capital of roller blade manufacturers operating solely in the United States? Substantiate your answer by outlining how Blades' characteristics distinguish it from domestic roller blade manufacturers.
2. According to the CAPM, how would Blades' required rate of return be affected by an expansion into Thailand? How do you reconcile this result with your answer to question 1? Do you think Blades should use the required rate of return resulting from the CAPM to discount the cash flows of the Thai subsidiary to determine its NPV?
3. If Blades borrows funds in Thailand to support its Thai subsidiary, how would this affect its cost of capital? Why?
4. Given the high level of interest rates in Thailand, the high level of exchange rate risk, and the high (perceived) level of country risk, do you think Blades will be more or less likely to use debt in its capital structure as a result of its expansion into Thailand? Why?