International cost of capitalPresentation Transcript
COST OF CAPITAL (AN INTERNATIONAL PERSPECTIVE)
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
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.
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
k c = ( D ) k d ( 1 _ t ) + ( E ) k e
D + E D + E
D is the amount of debt of the firm
E is the equity of the firm
k d is the before-tax cost of its debt
t is the corporate tax rate
k e 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 capital (%) Investment ($) IRR K global K local I local I global The Firm’s Investment Decision and the Cost of Capital
Capital Market Segmentation Capital Market segmentation is a financial market imperfection caused by government constraints and investor perceptions. The most important imperfections are : * Asymmetric Information * Transaction Cost * Foreign Exchange Risk * Takeover Defenses * Small Country Bias * Political Risk * Regulatory Barriers
Cost of Capital for MNCs Vs Domestic Firms * Size of Firm * Foreign Exchange Risk * Access to International Capital Markets * International Diversification Effect * Political Risk * Country Risk * Tax Concessions
Cost of Capital for MNCs Possible access to low-cost foreign financing Preferential treatment from creditors Greater access to international capital markets Larger size International diversification Exposure to exchange rate risk Exposure to country risk Cost of capital Probability of bankruptcy
Cost of Capital Cost of Capital Debt Ratio
Cost of Debt The explicit cost of debt for a firm may be defined as the discount rate that equates the net proceeds of the debt issue with the present value of interest and principal payments :
Cost of Debt Tax adjustments need to be made also. K t = K i (1 – t) Before Tax cost of capital need to be adjusted for any foreign exchange loss or gain. K i = (K f x K a ) – K p Where, K t = After Tax Cost K i = Before Tax Cost K f = Before Tax Cost in Foreign Currency K a = Additional interest due to exchange rate change K p = Additional principal due to exchange rate change
A US Co. borrows French franks for one year at 7%. During the year, the franc appreciates 9% relative to the dollar. US tax rate is 35%. What is the After-Tax Cost of this debt in US$ terms ? K i = ( K f x K a ) + K p = (0.07 x 1.09) + 0.09 = 16.63 % K t = K i 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. R i = R f x β i + (R m – R f ) Β i = Cov. (R i R M ) -------------- Var (R M )
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. R i = R f + β i IND (R IND – R f ) Versus R i = R f + β i W (R W – R f )
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 % R f = 6 % R IBM = 6 + 1(12-6) = 12 % If Capital markets are integrated, W and (β -----) = 0.8 IBM Calculate cost of Capital R IBM = 6 + 0.8 (12 – 6) = 10.8 %
Levered Vs Unlevered Firm In CAPM equation : R l = r f + β l (r m – r f ) So β l is for levered firm To calculate β for unlevered firm (β ul ) the following equation will be used : β 1 β ul = ----------------- 1 + (1-t) D/E Β 1 = 1.1 1.1 D/E = 0.6 β ul = ------------------ = 0.79 Tax = 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 Canada U.S. Germany Japan Costs of Debt (%)
Solutions to Questions. (ENU-1 to 3) Pg 414 6 T 6 M r (Cov) (18)(15)(0.9) 1. β T M ---------- = --------- = ----------------- = 1.08 6 M 2 (Var m ) (15)2 (18)(10)(0.6) β T M = ----------------- = 1.08 (10) 2
Solutions to Questions. (ENU-1 to 3) Pg 414 2. R T = R f + (R m – R f ) β T M 5 + (14 – 5) (1.08) = 14.72 % 3. R T = R f + (R m – R R ) β T M 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