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 %