Change in Cost of Capital. Assume that Naperville Co. will use equity to finance

Question

Change in Cost of Capital. Assume that Naperville Co. will use equity to finance a project in Switzerland, while Lombard Co. will rely on a dollar-denominated loan to finance a project in Switzerland, and Addison Co. will rely on a Swiss franc-denominated loan to finance a project in Switzerland. The firms will arrange their financing in one month. This week, the U.S. risk-free long-term interest rate declined, but interest rates in Switzerland did not change. Do you think the estimated cost of capital for the projects by each of these three U.S. firms increased, decreased, or remained unchanged?

Naperville decreased, Lombard Co. decreased, and Addison Co. remains unchanged.

Naperville increased, Lombard Co. increased, and Addison Co. remains unchanged.

Naperville remains unchanged, Lombard Co. remains unchanged, and Addison Co. decreased.

Naperville decreased, Lombard Co. increased, and Addison Co. remains unchanged.

Naperville decreased, Lombard Co. decreased, and Addison Co. remains unchanged.

Naperville increased, Lombard Co. increased, and Addison Co. remains unchanged.

Naperville remains unchanged, Lombard Co. remains unchanged, and Addison Co. decreased.

Naperville decreased, Lombard Co. increased, and Addison Co. remains unchanged.

Explanation / Answer

Since risk free rate of US has decreased and that in switzerland has remained the same , by interest rate parity US dollar will increase in value compared to swiss francs. Thus less US dollars will have to be raised to meet same swiss franc spending in switzerland leading to lower equity/ debt raised in US causing decreased cost of capital for Naperville and Lombard. Since Addison is raising capital in swiss denominated loan and interest rate in sitzerland hasnot changed its cost of capital will remain unchanged. Option 1 is correct

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