Download Cost of Foreign Debt Versus Equity

Cost of Foreign Debt Versus Equity. Carazona Inc. is a U.S. firm that has a large subsidiary in
Indonesia. It wants to finance the subsidiary’s operations in Indonesia. However, the cost of
debt is presently about 30 percent there for firms like Carazona or government agencies that
have a very strong credit rating. A consultant suggests to Carazona that it should use equity
financing there to avoid the high interest expense. He suggests that since Carazona’s cost of
equity in the U.S. is about 14 percent, so the Indonesian investors should be satisfied with a
return of about 14 percent as well. Clearly explain why the consultant’s advice is not logical.
That is, explain why Carazona’s cost of equity in Indonesia would not be less than
Carazona’s cost of debt in Indonesia.
The cost of equity is based on a risk-free interest rate plus a risk premium. The risk-free
interest rate is about 30 percent so Indonesian investors are not going to invest in
Carazona Inc. for less than the risk-free rate.