Case Study Mki - Blades

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 (CFO), 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.
Holts 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 be able 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 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 subsidiarys 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 further over the next few years. Furthermore, Holt has already
conducted a country risk analysis for Thailand, which 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 firms exposure to U.S. market conditions would be reduced
by the 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?

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BLADES, INC.

rate is 5 percent and the required return on the market is 12 percent.

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