1.
CHAPTER 14CHAPTER 14
THE COST OFTHE COST OF
CAPITAL FORCAPITAL FOR
FOREIGNFOREIGN
INVESTMENTSINVESTMENTS
2.
CHAPTER OVERVIEW:CHAPTER OVERVIEW:
I.I. THE COST OF EQUITY CAPITALTHE COST OF EQUITY CAPITAL
II.II. THE WEIGHTED AVERAGE COSTTHE WEIGHTED AVERAGE COST
OF CAPITAL FOR FOREIGNOF CAPITAL FOR FOREIGN
PROJECTSPROJECTS
III.III. THE ALL-EQUITY COST OFTHE ALL-EQUITY COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
IV.IV. DISCOUNT RATESDISCOUNT RATES
V.V. ESTABLISHING A WORLDWIDEESTABLISHING A WORLDWIDE
CAPITAL STRUCTURECAPITAL STRUCTURE
3.
I. THE COST OF EQUITYI. THE COST OF EQUITY
CAPITALCAPITAL
A.A. DefinitionDefinition
1. the minimum (required) rate of1. the minimum (required) rate of
returnreturn
necessary to induce investors to buynecessary to induce investors to buy
or hold the firm’s stock.or hold the firm’s stock.
2. used to value future equity cash2. used to value future equity cash
flowsflows
3. determines common stock price3. determines common stock price
4.
THE COST OF EQUITYTHE COST OF EQUITY
CAPITALCAPITAL
B.B. Capital Asset Pricing ModelCapital Asset Pricing Model
rrii = r= rff ++ ΒΒii ( r( rmm - r- rff ))
where rwhere rii = the equity required rate= the equity required rate
rrff = the risk free return rate= the risk free return rate
ΒΒii= Cov(r= Cov(rmm, r, rii)/)/ σσ22
rrmm wherewhere
5.
THE COST OF EQUITYTHE COST OF EQUITY
CAPITALCAPITAL
Cov(rCov(rmm, r, rii) is the covariance between asset) is the covariance between asset
and market returns andand market returns and σσ22
rrmm , the variance, the variance
of market returns.of market returns.
6.
II.II. THE WEIGHTED AVERAGE COSTTHE WEIGHTED AVERAGE COST
OF CAPITAL FOR FOREIGN PROJECTSOF CAPITAL FOR FOREIGN PROJECTS
II.II.THE WEIGHTED AVERAGE COST OFTHE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
A.A. Weighted Average Cost of CapitalWeighted Average Cost of Capital
(WACC = k(WACC = k00))
kk00 = (1-L) k= (1-L) kee + L i+ L idd (1 - t)(1 - t)
where L = the parent’s debt ratiowhere L = the parent’s debt ratio
iidd (1 - t) = the after-tax debt cost(1 - t) = the after-tax debt cost
kkee = the equity cost of capital= the equity cost of capital
7.
THE WEIGHTED AVERAGE COST OFTHE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
kk00 is used as the discount rate in theis used as the discount rate in the
calculation of Net Present Value.calculation of Net Present Value.
2.2. Two CaveatsTwo Caveats
a. Weights must be a proportion usinga. Weights must be a proportion using
market, not book value.market, not book value.
b. Calculating WACC, weights must beb. Calculating WACC, weights must be
marginal reflecting future debtmarginal reflecting future debt
structure.structure.
8.
THE WEIGHTED AVERAGE COST OFTHE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
B.B. Costing Various Sources of FundsCosting Various Sources of Funds
1.1. Components of a New Investment (I)Components of a New Investment (I)
I = P + EI = P + E ff + D+ D ff
wherewhere I = require subsidiaryI = require subsidiary
financingfinancing
P = dollars by parentP = dollars by parent
EE ff = subsidiary’s retained= subsidiary’s retained
earningsearnings
DD = dollars from debt= dollars from debt
9.
THE WEIGHTED AVERAGE COST OFTHE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
2. First compute each component2. First compute each component
a.a. Parent’s company funds (kParent’s company funds (k00))
required rate equal to the marginalrequired rate equal to the marginal
cost of capitalcost of capital
b.b. Retained Earnings (kRetained Earnings (kss))
a function of dividends,a function of dividends,
withholding taxes, tax deferral,withholding taxes, tax deferral,
and transfer costs.and transfer costs.
kk = k= k (1-T)(1-T)
10.
THE WEIGHTED AVERAGE COST OFTHE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
c. Local Currency Debt (rc. Local Currency Debt (rff))
after-tax dollar cost of borrowingafter-tax dollar cost of borrowing
locallylocally
11.
THE WEIGHTED AVERAGE COST OFTHE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
C. Computing WACC(kC. Computing WACC(k11))
kk11 = k= k00 - a(k- a(kee --kkss) - b[ i) - b[ idd(1-t) - i(1-t) - iff ]]
12.
III.III. THE ALL-EQUITY COST OFTHE ALL-EQUITY COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
III.III. THE ALL-EQUITY COST OFTHE ALL-EQUITY COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
A.A. WACC sometimes awkwardWACC sometimes awkward
1. To go from the parent to the project1. To go from the parent to the project
2. Solution: Use all equity discount2. Solution: Use all equity discount
raterate
3. To calculate:3. To calculate:
kk**
= r= rff ++ ΒΒ**
( r( rmm - r- rff ))
13.
THE ALL-EQUITY COST OFTHE ALL-EQUITY COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
4.4. ΒΒ**
is the all-equity beta associated withis the all-equity beta associated with
the unleveraged cash flows.the unleveraged cash flows.
14.
THE ALL-EQUITY COST OFTHE ALL-EQUITY COST OF
CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
5. Unlevering beta obtained by5. Unlevering beta obtained by
where Bwhere B**
= the firm’s stock price beta= the firm’s stock price beta
D/E = the debt to equity ratioD/E = the debt to equity ratio
t = the firm’s marginal taxt = the firm’s marginal tax
EDt
e
/)1(1
*
−+
=
β
β
15.
IV.IV. DISCOUNT RATES FORDISCOUNT RATES FOR
FOREIGN PROJECTSFOREIGN PROJECTS
IV.IV. DISCOUNT RATES FOR FOREIGNDISCOUNT RATES FOR FOREIGN
PROJECTSPROJECTS
A.A. Systematic RiskSystematic Risk
1. Not diversifiable1. Not diversifiable
2. Foreign projects in non-2. Foreign projects in non-
synchronous economies should besynchronous economies should be
less correlated with domesticless correlated with domestic
markets.markets.
16.
DISCOUNT RATES FOR FOREIGNDISCOUNT RATES FOR FOREIGN
PROJECTSPROJECTS
3. Paradox: LDCs have greater political3. Paradox: LDCs have greater political
risk but offer higher probability ofrisk but offer higher probability of
diversification benefits.diversification benefits.
17.
DISCOUNT RATES FOR FOREIGNDISCOUNT RATES FOR FOREIGN
PROJECTSPROJECTS
B.B. Key Issues in Estimating ForeignKey Issues in Estimating Foreign
Project BetasProject Betas
-find firms publicly traded that share-find firms publicly traded that share
similar risk characteristicssimilar risk characteristics
-use the average beta as a proxy-use the average beta as a proxy
18.
DISCOUNT RATES FOR FOREIGNDISCOUNT RATES FOR FOREIGN
PROJECTSPROJECTS
1.1. Three Issues:Three Issues:
a.a. Should proxies be U.S. or localShould proxies be U.S. or local
companies?companies?
b.b. Which is the relevant baseWhich is the relevant base
portfolio to use?portfolio to use?
c.c. Should the market risk premium beShould the market risk premium be
based on U.S. or local market?based on U.S. or local market?
19.
DISCOUNT RATES FOR FOREIGNDISCOUNT RATES FOR FOREIGN
PROJECTSPROJECTS
2.2. Proxy CompaniesProxy Companies
a. Most desirable to use locala. Most desirable to use local
firmsfirms
b. Alternative:b. Alternative:
find a proxy industry in thefind a proxy industry in the
local marketlocal market
20.
DISCOUNT RATES FOR FOREIGNDISCOUNT RATES FOR FOREIGN
PROJECTSPROJECTS
3.3. Relevant Base (Market) PortfolioRelevant Base (Market) Portfolio
a. If capital markets are globallya. If capital markets are globally
integrated, choose world mkt.integrated, choose world mkt.
b. If not, domestic portfolio is bestb. If not, domestic portfolio is best
21.
DISCOUNT RATES FOR FOREIGNDISCOUNT RATES FOR FOREIGN
PROJECTSPROJECTS
4.4. Relevant Market Risk PremiumRelevant Market Risk Premium
a. Use the U.S. portfolioa. Use the U.S. portfolio
b. Foreign project: should haveb. Foreign project: should have
no higher than domestic riskno higher than domestic risk
and cost of capital.and cost of capital.
22.
V.V. ESTABLISHING AWORLDESTABLISHING AWORLD
WIDE CAPITAL STRUCTUREWIDE CAPITAL STRUCTURE
V.V. ESTABLISHING A WORLDWIDEESTABLISHING A WORLDWIDE
CAPITAL STRUCTURECAPITAL STRUCTURE
A.A. MNC Advantage:MNC Advantage:
uses more debt due touses more debt due to
diversificationdiversification
23.
ESTABLISHING AWORLD WIDEESTABLISHING AWORLD WIDE
CAPITAL STRUCTURECAPITAL STRUCTURE
B.B. What is proper capital structure?What is proper capital structure?
1.1. Borrowing in local currency helpsBorrowing in local currency helps
to reduce exchange rate riskto reduce exchange rate risk
2.2. Allow subsidiary to exceed parentAllow subsidiary to exceed parent
capitalization norm if local mkt.capitalization norm if local mkt.
has lower costs.has lower costs.
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