Amco is a U.S. company that conducts major importing and exporting business in Japan, whereby all transactions are invoiced in dollars. It obtained debt in the United States at an interest rate of 10 percent per year. The long-term risk-free rate in the United States is 8 percent. The stock market return in the United States is expected to be 14 percent annually. Amco’s beta is 1.2. Its target capital structure is 30 percent debt and 70 percent equity. Amco is subject to a 25 percent corporate tax rate. Estimate the cost of capital to Amco.
Amco has no subsidiaries in foreign countries but plans to replace some of its dollar-denominated debt with Japanese yen–denominated debt since Japanese interest rates are low. It will obtain yen- denominated debt at an interest rate of 5 percent. It cannot effectively hedge the exchange rate risk resulting from this debt because of parity conditions that make the price of derivatives contracts re?ect the interest rate differential. How could Amco reduce its exposure to the exchange rate risk resulting from the yen-denominated debt without moving its operations?