Internationalcostofcapital 110216232906-phpapp01

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Internationalcostofcapital 110216232906-phpapp01

  1. 1. COST OF CAPITAL (AN INTERNATIONAL PERSPECTIVE)
  2. 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. 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. 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. 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. 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. 7. Cost of Capital : Terms Used * Cost of Specific Source * Average Cost of Capital * Marginal Cost of Capital
  8. 8. Determination of Proportions * Book Values * Market Values * Financing Plan
  9. 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. 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. 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. 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 ($) IRR K global K local Ilocal Iglobal The Firm’s Investment Decision and the Cost of Capital
  13. 13. Capital Market Segmentation Capital Market segmentation is a financial market imperfection caused by government constraints and investor perceptions. The most important imperfections are : * Asymmetric Information * Transaction Cost * Foreign Exchange Risk * Takeover Defenses * Small Country Bias * Political Risk * Regulatory Barriers
  14. 14. Cost of Capital for MNCs Vs Domestic Firms * Size of Firm * Foreign Exchange Risk * Access to International Capital Markets * International Diversification Effect * Political Risk * Country Risk * Tax Concessions
  15. 15. Cost of Capital for MNCs Possible access to low- cost foreign financing Preferential treatment from creditorsGreater access to international capital markets Larger size International diversification Exposure to exchange rate risk Exposure to country risk Cost of capital Probability of bankruptcy
  16. 16. Debt’s Tradeoff Cost of Capital CostofCapital Debt Ratio
  17. 17. Cost of Debt The explicit cost of debt for a firm may be defined as the discount rate that equates the net proceeds of the debt issue with the present value of interest and principal payments :
  18. 18. Cost of Debt Tax adjustments need to be made also. Kt = Ki (1 – t) Before Tax cost of capital need to be adjusted for any foreign exchange loss or gain. Ki = (Kf x Ka) – Kp Where, Kt = After Tax Cost Ki = Before Tax Cost Kf = Before Tax Cost in Foreign Currency Ka = Additional interest due to exchange rate change Kp = Additional principal due to exchange rate change
  19. 19. A US Co. borrows French franks for one year at 7%. During the year, the franc appreciates 9% relative to the dollar. US tax rate is 35%. What is the After-Tax Cost of this debt in US$ 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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
  33. 33. Solutions to Questions. (ENU-1 to 3) Pg 414 2. RT = Rf+ (Rm – Rf) βT M 5 + (14 – 5) (1.08) = 14.72 % 3. RT = Rf+ (Rm – RR) βT M 5 + (12 – 5) (1.08) = 12.56 %
  34. 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
  35. 35. 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 %

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