2. International Cost of Capital
* Multinational Started by having
Companies operations in more
than country
But now are
multinational from the
angle of capital
structure also.
* Segmented Capital Markets
* Integrated Capital Markets
3. 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.
4. 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.
5. 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.
6. There is strong evidence that much risk
that is systematic from a domestic
standpoint is unsystematic from a
global standpoint. If 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.
7. Cost of Capital : Terms Used
* Cost of Specific Source
* Average Cost of Capital
* Marginal Cost of Capital
9. 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.
10. 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 firm
E is the equity of the firm
kd is the before-tax cost of its debt
t is the corporate tax rate
ke is the cost of financing with equity
11. 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.
12. •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.
costofcapital(%)
Investment ($)
IRR
K global
K local
Ilocal Iglobal
The Firm’s Investment Decision and the
Cost of Capital
13. Capital Market Segmentation
Capital Market segmentation is a financial market
imperfection caused by government constraints and
investor perceptions.
The most important imperfections are :
* Asymmetric Information
* Transaction Cost
* Foreign Exchange Risk
* Takeover Defenses
* Small Country Bias
* Political Risk
* Regulatory Barriers
14. Cost of Capital for MNCs Vs Domestic
Firms
* Size of Firm
* Foreign Exchange Risk
* Access to International Capital Markets
* International Diversification Effect
* Political Risk
* Country Risk
* Tax Concessions
15. Cost of Capital for MNCs
Possible
access to low-
cost foreign
financing
Preferential
treatment from
creditorsGreater access
to international
capital markets
Larger size
International
diversification
Exposure to
exchange rate
risk
Exposure to
country risk
Cost of
capital
Probability of
bankruptcy
17. Cost of Debt
The explicit cost of debt for a firm may be defined as
the discount rate that equates the net proceeds of the
debt issue with the present value of interest and
principal payments :
18. Cost of Debt
Tax adjustments need to be made also.
Kt = Ki (1 – t)
Before Tax cost of capital need to be adjusted for any
foreign exchange loss or gain.
Ki = (Kf x Ka) – Kp
Where,
Kt = After Tax Cost
Ki = Before Tax Cost
Kf = Before Tax Cost in Foreign Currency
Ka = Additional interest due to exchange rate
change
Kp = Additional principal due to exchange
rate change
19. A US Co. borrows French franks for one year at 7%.
During the year, the franc appreciates 9% relative to
the dollar. US tax rate is 35%. What is the After-Tax
Cost of this debt in US$ 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 %
20. 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
21. 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)
22. 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 + βi
IND
(RIND – Rf)
Versus
Ri = Rf + βi
W
(RW – Rf)
23. 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.
24. 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 %
25. 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
= ------------------ = 0.79
Tax = 35 % 1 + (1-0.35)(0.6)
26. 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.
27. 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.
28. 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.
29. 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
30. 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
31. Costs of Capital Across
Countries
0
2
4
6
8
10
12
14
1990 1992 1994 1996 1998 2000 2002
Canada
U.S.
Germany
Japan
CostsofDebt(%)
32. 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
34. 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
