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COST OF CAPITAL
Cost of Capital to Evaluate Foreign Investments
• Normal rule: cash flows are discounted using the WACC which
incorporates inflation.
• If we are dealing with a foreign investment then the inflation rates in
different countries will be different. Therefore the WACC must be
adjusted.
Example:
A South African company is considering a foreign investment in the UK
which bears the same risks as its current operations. The expected rate of
inflation in the UK is 3% per annum and in SA is 9% per annum. Nominal
discount rate applicable to SA operations is 22%.
STEP 1: Calculate the real rate (excluding inflation) for the SA
operations
(1 + i)(1 + r) = (1 + n)
(1 + 0.09)(1 + r) = (1 + 0.22)
(1 + r) = (1.22)/(1.09)
(1 + r) = 1.11927 r = 11.93% This is the real rate (ex inflation) in SA
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