International Finance - 3 DAYS DUE
Multinational Financial Management
Alan Shapiro
7th Edition
J.Wiley & Sons
Power Points by
Joseph F. Greco, Ph.D.
California State University, Fullerton
CHAPTER 14
THE COST OF CAPITAL FOR FOREIGN INVESTMENTS
CHAPTER OVERVIEW:
I. THE COST OF EQUITY CAPITAL
II. THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
III. DISCOUNT RATES FOR FOREIGN INVESTMENTS
IV. THE COST OF DEBT CAPITAL
V. ESTABLISHING A WORLDWIDE CAPITAL STRUCTURE
I. THE COST OF EQUITY CAPITAL
A. Definition
1. the minimum (required) rate of return
necessary to induce investors to buy
or hold the firm’s stock.
2. used to value future equity cash flows
3. determines common stock price
THE COST OF EQUITY CAPITAL
B. Capital Asset Pricing Model
ri = rf + i ( rm - rf )
where ri = the equity required rate
rf = the risk free return rate
i= Cov(rm, ri)/ 2 rm where
THE COST OF EQUITY CAPITAL
Cov(rm, ri) is the covariance between asset and market returns and 2 rm , the variance of market returns.
II. THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
II. FOREIGN PROJECTS
A. Weighted Average Cost of Capital (WACC = k0)
k0 = (1-L) ke + L id (1 - t)
where L = the parent’s debt ratio
id (1 - t) = the after-tax debt cost
ke = the equity cost of capital
THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
k0 is used as the discount rate in the
calculation of Net Present Value.
2. Two Caveats
a. Weights must be a proportion using
market, not book value.
b. Calculating WACC, weights must be
marginal reflecting future debt
structure.
III. DISCOUNT RATES FOR FOREIGN INVESTMENTS
III. DISCOUNT RATES AND FOREIGN PROJECTS
A. Systematic Risk
1. Not diversifiable
2. Foreign projects in non-synchronous economies should be less correlated with domestic markets.
DISCOUNT RATES FOR FOREIGN INVESTMENTS
3. Paradox: LDCs have greater political
risk but offer higher probability of
diversification benefits.
DISCOUNT RATES FOR FOREIGN INVESTMENTS
B. Key Issues in Estimating Foreign Project Betas
-find firms publicly traded that share
similar risk characteristics
-use the average beta as a proxy
DISCOUNT RATES FOR FOREIGN INVESTMENTS
1. Three Issues:
a. Should proxies be U.S. or local
companies?
b. Which is the relevant base portfolio to use?
c. Should the market risk premium be based on U.S. or local market?
DISCOUNT RATES FOR FOREIGN INVESTMENTS
2. Proxy Companies
a. Most desirable to use local firms
b. Alternative:
find a proxy industry in the local market
DISCOUNT RATES FOR FOREIGN INVESTMENTS
3. Relevant Base (Market) Portfolio
a. If capital markets are globally
integrated, choose world mkt.
b. If not, domestic portfolio is best
DISCOUNT RATES FOR FOREIGN INVESTMENTS
4. Relevant Market Risk Premium
a. Use the U.S. portfolio
b. Foreign project: should have
no higher than domestic risk
and cost of capital.
IV. THE COST OF DEBT CAPITAL
The use of sovereign risk premium is appropriate for estimating the cost of debt associated with a foreign project.
V. ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE
V. MNC ADVANTAGE IN ESTABLISHING A WORLDWIDE CAPITAL STRUCTURE:
It uses more debt due to diversification
ESTABLISHING A WORLD WIDE CAPITAL STRUCTURE
A. What is proper capital structure?
1. Borrowing in local currency helps
to reduce exchange rate risk
2. Allow subsidiary to exceed parent
capitalization norm if local mkt.
has lower costs.