Japanese electrical engineering firm Kandenko Co. plans to acquire a 40% ownership stake in a Philippine peer, PHOC Co., as part of its global expansion. The current Japanese Treasury bond rate is 5% and the expected inflation is 3% in Japan per annual. The expected inflation rate in the Philippines is 6% annually. To compensate for the uncommon political and economic risks, investors would require an additional 2% return for any investment in the Philippines. Based on the target’s interest coverage ratio, its credit rating is estimated to be AA. The current interest rate on AA-rated Japanese corporate bond is 6.25%. Kandenko Co. has the marginal tax rate of 23% and its pre-tax cost of debt is 6%. Kandenko’s total capitalization consists of common equity and debt only. Kandenko Co. has projected debt to total capital ratio is 0.3.
PHOC’s beta and the Philippine country beta are estimated to be 1.3 and 0.7, respectively. The equity premium is estimated to be 6% based on the spread between the prospective return on the country’s equity index and the estimated risk free rate of return. Given the PHOC’s current market capitalization, the firm size premium (FSP) is estimated at 1%.
What is the appropriate weighted average cost of capital Kandenko Co. should use to discount the target’s projected annual cash flows, expressed in its own local currency?