Cost of Foreign Debt versus Equity
Response to the following problem:
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 currently 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 United States is about 14 percent, he 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.