Jurgen Knudsen has been hired to provide industry expertise to Henrik Sandell, CFA, an

analyst for a pension plan managing a global large-cap fund internally. Sandell is concerned
about one of the fund’s larger holdings, auto parts manufacturer Kruspa AB. Kruspa currently
operates in 80 countries, with the previous year’s global revenues at €5.6 billion. Recently,
Kruspa’s CFO announced plans for expansion into Trutan, a country with a developing
economy. Sandell worries that this expansion will change the company’s risk profile and
wonders if he should recommend a sale of the position.

Sandell provides Knudsen with the basic information. Kruspa’s global annual free cash flow
to the firm is €500 million, and earnings are €400 million. Sandell estimates that cash flow
will level off at a 2% rate of growth. Sandell also estimates that Kruspa’s after-tax free cash
flow to the firm on the Trutan project for next three years is, respectively, €48 million, €52
million, and €54.4 million. Kruspa recently announced a dividend of €4.00 per share of stock.
For the initial analysis, Sandell requests that Knudsen ignore possible currency fluctuations.
He expects the Trutanese plant to sell only to customers within Trutan for the first three
years. Knudsen is asked to evaluate Kruspa’s planned financing of the required €100 million
in Sweden with an €80 million public offering of 10-year debt and the remainder with an
equity offering.

Additional information:

Equity risk premium, Sweden 4.82%

Risk-free rate of interest, Sweden 4.25%

Industry debt-to-equity ratio 0.3

Market value of Kruspa’s debt €900 million

Market value of Kruspa’s equity €2.4 billion

Kruspa’s equity beta 1.3

Kruspa’s before-tax cost of debt 9.25%

Trutan credit A2 country risk premium 1.88%

Corporate tax rate 37.5%

Interest payments each year Level

Question
As part of the sensitivity analysis of the effect of the new project on the company's cost of
capital, Sandell is estimating the cost of equity of the Trutan project considering that the
Trutan project requires a country equity premium to capture the risk of the project. The cost
of equity for the project in this case is closest to:
1. 10.52%.
2. 19.91%.
3. 28.95%.