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COST OF
CAPITAL
(AN INTERNATIONAL PERSPECTIVE)
International Cost of Capital
* Multinational Started by having Companies operations in
morethan country
But now are multinational
from the angle of capital
structure also.
* Segmented Capital Markets
* Integrated Capital Markets
Cost of Capital
* If the international markets were
integrated, it would not have mattered
much as to whether firms raise money from
domestic market or international markets.
* International listing can lessen the
negative effects of segmented Capital
Markets.
Cost of Capital
* Cost of capital is the minimum rate of return an investment project must generate in order to pay its financing cost.
• Difference between ‘risk of firm’ and ‘risk of project.
• A project cost of capital is a function of the risk of the project itself, not the risk of firm undertaking the project.
Even if foreign investments are riskier than domestic investments, that does not mean that those risks must lead to a higher cost of capital for the former. The basic insight of the capital asset pricing model (CAPM) is that only the systematic component of risk is priced; diversifiable risk must be borne at a zero price.
There is strong evidence that much risk
that is systematic from a domestic
standpoint is unsystematic from a
global stand point. I f risk is measured
relative to a domestically-diversified
portfolio, then foreign projects
probably have lower systematic risk
than comparable domestic
investments, and so should require
lower returns.
Cost of Capital : Terms Used
* Cost of Specific Source
* Average Cost of Capital
* Marginal Cost of Capital
Determination of Proportions
* Book Values
* Market Values
* Financing Plan
Weighted Average Cost of Capital
Weighted Average Cost of Capital is a
weighted average of the component costs :
the cost of equity; the cost of preferred
stock; cost of retained earnings; and cost of
debt. It is normally used as the firm’s cost of
capital.
WEIGHTED AVERAGE COST OF CAPITAL
• A firm’s weighted average cost of capital
kc = ( D ) kd ( 1 _ t ) + ( E ) ke D + E D + E
Where
D is the amount of debt of the firmE is the equity of the firmkd is the before-tax cost of its debtt is the corporate tax rateke is the cost of financing with equity
Role of Diversification in Cost of Capital
Even if foreign investments are riskier than
domestic investments that does not mean
that those risks must lead to a higher cost of
capital for the former.
A firm that can reduce its cost of capital will
increase the profitable capital expenditure
that the firm can take on and increase the
wealth of the shareholders
Internationalising the firms cost of capital is
one such policy.
•AA firm that can reduce its cost of capital will increase the profitable capital expenditures that the firm can take on and increase the wealth of the shareholders.•IInternationalizing the firm’s cost of capital is one such policy.
cost
of c
apita
l (%
)
Investment ($)
IRR
K global
K local
Ilocal Iglobal
The Firm’s Investment Decision and the Cost of Capital
Capital Market Segmentation
Capital Market segmentation is a financial
market imperfection caused by government
constraints and investor perceptions.
The most important imperfections are :
* Asymmetric Information
* Transaction Cost
* Foreign Exchange Risk
* Takeover Defenses
* Small Country Bias
* Political Risk
* Regulatory Barriers
Cost of Capital for MNCs Vs Domestic Firms
* Size of Firm
* Foreign Exchange Risk
* Access to International Capital Markets
* International Diversification Effect
* Political Risk
* Country Risk
* Tax Concessions
Cost of Capital for MNCs
Possible access to low-
cost foreign financing
Preferential treatment from
creditorsGreater access to international capital markets
Larger size
International diversification
Exposure to exchange rate
risk
Exposure to country risk
Cost of capital
Probability of bankruptcy
Debt’s Tradeoff
Cost of Capital
Co
st o
f C
apit
al
Debt Ratio
Cost of Debt
The explicit cost of debt for a firm may be
defined as the discount rate that equates the
net proceeds of the debt issue with the
present value of interest and principal
payments :
Cost of Debt
Tax adjustments need to be made also.Kt = Ki (1 – t)
Before Tax cost of capital need to be adjusted for any foreign exchange loss or gain.
Ki = (Kf x Ka) – Kp
Where,Kt = After Tax CostKi = Before Tax CostKf = Before Tax Cost in Foreign CurrencyKa = Additional interest due to exchange rate changeKp = Additional principal due to exchange rate change
A US Co. borrows French franks for one year
at 7%. During the year, the franc appreciates
9% relative to the dollar. US tax rate is 35%.
What is the After-Tax Cost of this debt in US$
terms ?
Ki = ( Kf x Ka) + Kp
= (0.07 x 1.09) + 0.09
= 16.63 %
Kt = Ki x (I – T)
= 0.1663 (1-0.35)
= 10.81 %
THE COST OF EQUITY
The cost of Equity Capital is the expected
return that equity investors require.
Dividend Valuation
Model
Cost of Equity Capital Asset Pricing
Model
Price Earnings Model
The main difference between the three
approaches is that CAPM emphasizes only on
the systematic risk and the others on total
risk.
As such it is CAPM that is widely used.
Ri = Rf x βi + (Rm – Rf)
Βi = Cov. (Ri RM)-------------- Var (RM)
Cost of Capital in Segmented V/s Integrated Markets
If capital markets are segmented then
investors can only invest domestically. This
means that the market portfolio in the CAPM
formula would be the domestic portfolio
instead of the world portfolio.
Ri = Rf + βiIND (RIND – Rf)
Versus
Ri = Rf + βiW (RW – Rf)
Cost of Capital in Segmented V/s Integrated Markets
Thus, integration or segmentation of
international financial markets has major
implications for determining the cost of
capital.
In segmented capital markets, the same
future cash flows are likely to be priced
differently across countries, as they would be
viewed as having different systematic risks
by investors from different countries.
Cost of Equity
Given :US
US domestic β of IBM (β-----) =1.0
IBM
Expected return on US Market portfolio =
12 %
Rf =
6 %
RIBM = 6 + 1(12-6) =
12 %
If Capital markets are integrated, W
and (β -----)= 0.8 IBM
Calculate cost of Capital
RIBM = 6 + 0.8 (12 – 6) =
10.8 %
Levered Vs Unlevered Firm
In CAPM equation :
Rl = rf + βl (rm – rf)
So βl is for levered firm
To calculate β for unlevered firm (βul) the
following equation will be used :β1
βul =-----------------1 + (1-t) D/E
Β1 = 1.1 1.1 D/E = 0.6 βul =------------------ = 0.79Tax = 35 % 1 + (1-0.35)(0.6)
Empirical Evidence
* Chan, Karolyi & Stulz (1992)
Capital Markets are integrated
* French & Poterba (1991)
Investors diversify to limited extent
* Mittoo (1992)
The advantage of diversification to
cross-listed stocks.
Empirical Evidence
* There do appear to be differences in the
cost of capital in different countries.
* When markets are imperfect
international financing can lower the firms
cost of capital.
* One way to achieve this is to
internationalisation of ownership structure.
Cross-Border Listings of Stocks
• Cross-border listings of stocks have become quite popular among major corporations.
• The largest contingent of foreign stocks are listed on the London Stock Exchange.
• U.S. exchanges attracted the next largest contingent of foreign stocks.
International Listing
Advantages :
* Expand Investor Base
* High Stock Price results in Low Cost of
Capital
* Secondary Market–wide
(Helps to raise capital in foreign market)
* Better Liquidity of Company Stock
* Better Visibility of Company
Cost of International Listing :
* Cost of disclosures & fee
* Volatility Spillovers
* May acquire controlling interest
Miller (1999) in his study confirms that dual
listing :
* High Share Price
* Low Cost of Capital
Costs of Capital Across Countries
0
2
4
6
8
10
12
14
1990 1992 1994 1996 1998 2000 2002
Canada
U.S.
GermanyJapanC
osts
of
Deb
t (%
)
Solutions to Questions. (ENU-1 to 3) Pg 414
6T 6Mr (Cov) (18)(15)(0.9) 1. βT
M ---------- = --------- = ----------------- = 1.08 6M
2 (Varm) (15)2
(18)(10)(0.6) βT
M = ----------------- = 1.08 (10)2
Solutions to Questions. (ENU-1 to 3) Pg 414
2. RT = Rf+ (Rm – Rf) βTM
5 + (14 – 5) (1.08) = 14.72 %
3. RT = Rf+ (Rm – RR) βTM
5 + (12 – 5) (1.08) = 12.56 %
Answers
1. Correlation and volatility of the foreign
affiliate’s cash flows relative to domestic
operations.
2. By financing assets that generate
foreign currency cash flows with liabilities
denominated in those same foreign
currencies.
3. Invest parent company’s funds as
-- debt not equity
-- back to back loans
-- parallel loans
Answers
4 (a) 2/3 x 12% + 1/3 x 7% = 10.33 %
(b) 1.21------------- = 0.93 1 + (1-0.4)2
5. = 12 + 0.85 (19-12) = 17.95 %