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INTERNATIONAL
CAPITAL
BUDGETING
AND CAPITAL
STRUCTURE
Maribel V. Villaverde
Fifth Edition
International Capital Structure
and the Cost of Capital
17-1
KEY TAKEAWAYS
•Capital structure is how a company funds its overall
operations and growth.
•Debt consists of borrowed money that is due back to
the lender, commonly with interest expense.
•Equity consists of ownership rights in the company,
without the need to pay back any investment.
•The debt-to-equity (D/E) ratio is useful in determining
the riskiness of a company's borrowing practices.
WHAT IS CAPITAL STRUCTURE?
• Capital structure is the particular combination
of debt and equity used by a company to finance its
overall operations and growth.
• Equity capital arises from ownership shares in a company
and claims to its future cash flows and profits. Debt comes
in the form of bond issues or loans, while equity may
come in the form of common stock, preferred stock, or
retained earnings. Short-term debt is also considered to
be part of the capital structure.
COST OF CAPITAL
• The cost of capital is the minimum rate of return an
investment project must generate in order to pay its
financing costs.
• For a levered firm, the financing costs can be
represented by the weighted average cost of capital:
K = (1 – )Kl + (1 – t)i
17-3
WEIGHTED AVERAGE COST OF CAPITAL
Where
K = weighted average cost of capital
Kl = cost of equity capital for a levered firm
i = pretax cost of debt
 = debt to total market value ratio
t = marginal corporate income tax rate
K = (1 – )Kl + (1 – t)i
17-4
THE FIRM’S INVESTMENT DECISION AND THE
COST OF CAPITAL
• A 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.
• Internationalizing the firm’s
cost of capital is one such
policy.
Investment ($)
K global
K local
Ilocal Iglobal
IRR
17-5
COST OF CAPITAL IN SEGMENTED VS.
INTEGRATED MARKETS
• The cost of equity capital (Ke) of a firm is the expected return on the
firm’s stock that investors require.
• This return is frequently estimated using the Capital Asset Pricing Model
(CAPM):
where bi=
Cov(Ri ,RM)
Var(RM)
Ri = Rf + bi(RM – Rf)
17-6
COST OF CAPITAL IN SEGMENTED VS.
INTEGRATED MARKETS
If capital markets are segmented, then investors can
only invest domestically. This means that the market
portfolio (M) in the CAPM formula would be the
domestic portfolio instead of the world portfolio.
versus
Clearly integration or segmentation of international financial
markets has major implications for determining the cost of
capital.
Ri = Rf + bi (RU.S. – Rf)
U.S.
Ri = Rf + bi (RW – Rf)
W
17-7
DOES THE COST OF CAPITAL
DIFFER AMONG COUNTRIES?
• There do appear to be differences in the cost of capital
in different countries.
• When markets are imperfect, international financing can
lower the firm’s cost of capital.
• One way to achieve this is to internationalize the firm’s
ownership structure.
17-8
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.
17-9
CROSS-BORDER LISTINGS OF STOCKS
Cross-border listings of stocks benefit a company in the
following ways.
1. The company can expand its potential investor base,
which will lead to a higher stock price and lower cost of
capital.
2. Cross-listing creates a secondary market for the
company’s shares, which facilitates raising new capital in
foreign markets.
3. Cross-listing can enhance the liquidity of the company’s
stock.
4. Cross-listing enhances the visibility of the company’s
name and its products in foreign marketplaces.
17-10
CROSS-BORDER LISTINGS OF STOCKS
Cross-border listings of stocks do carry costs.
1. It can be costly to meet the disclosure and listing
requirements imposed by the foreign exchange and
regulatory authorities.
2. Once a company’s stock is traded in overseas markets, there
can be volatility spillover from these markets.
3. Once a company’s stock is make available to foreigners, they
might acquire a controlling interest and challenge the
domestic control of the company.
17-11
CROSS-BORDER LISTINGS OF STOCKS
On average, cross-border listings of stocks appears to be a
profitable decision.
The benefits outweigh the costs.
17-12
THE EFFECT OF FOREIGN EQUITY OWNERSH
RESTRICTIONS
• While companies have incentives to internationalize
their ownership structure to lower the cost of capital and
increase market share, they may be concerned with the
possible loss of corporate control to foreigners.
• In some countries, there are legal restrictions on the
percentage of a firm that foreigners can own.
• These restrictions are imposed as a means of ensuring
domestic control of local firms.
17-13
PRICING-TO-MARKET PHENOMENON
• Suppose foreigners, if allowed, would like to buy 30
percent of a Korean firm.
• But they are constrained by ownership constraints
imposed on foreigners to purchase at most 20 percent.
• Because this constraint is effective in limiting desired
foreign ownership, foreign and domestic investors many
face different market share prices.
• This dual pricing is the pricing-to-market
phenomenon.
17-14
ASSET PRICING UNDER FOREIGN
OWNERSHIP RESTRICTIONS
• An interesting outcome is that the firm’s cost of capital
depends on which investors, domestic or foreign, supply
capital.
• The implication is that a firm can reduce its cost of
capital by internationalizing its ownership structure.
17-15
THE FINANCIAL STRUCTURE
OF SUBSIDIARIES.
• There are three different approaches to determining
the subsidiary’s financial structure.
1. Conform to the parent company's norm.
2. Conform to the local norm of the country where the
subsidiary operates.
3. Vary judiciously to capitalize on opportunities to
lower taxes, reduce financing costs and risk, and take
advantage of various market imperfections.
17-16
THE FINANCIAL STRUCTURE
OF SUBSIDIARIES.
• In addition to taxes, political risk should be given due
consideration in the choice of a subsidiary’s financial
structure.
17-17

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Cost of capital structure and international budgeting

  • 2. Fifth Edition International Capital Structure and the Cost of Capital 17-1 KEY TAKEAWAYS •Capital structure is how a company funds its overall operations and growth. •Debt consists of borrowed money that is due back to the lender, commonly with interest expense. •Equity consists of ownership rights in the company, without the need to pay back any investment. •The debt-to-equity (D/E) ratio is useful in determining the riskiness of a company's borrowing practices.
  • 3. WHAT IS CAPITAL STRUCTURE? • Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. • Equity capital arises from ownership shares in a company and claims to its future cash flows and profits. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings. Short-term debt is also considered to be part of the capital structure.
  • 4. COST OF CAPITAL • The cost of capital is the minimum rate of return an investment project must generate in order to pay its financing costs. • For a levered firm, the financing costs can be represented by the weighted average cost of capital: K = (1 – )Kl + (1 – t)i 17-3
  • 5. WEIGHTED AVERAGE COST OF CAPITAL Where K = weighted average cost of capital Kl = cost of equity capital for a levered firm i = pretax cost of debt  = debt to total market value ratio t = marginal corporate income tax rate K = (1 – )Kl + (1 – t)i 17-4
  • 6. THE FIRM’S INVESTMENT DECISION AND THE COST OF CAPITAL • A 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. • Internationalizing the firm’s cost of capital is one such policy. Investment ($) K global K local Ilocal Iglobal IRR 17-5
  • 7. COST OF CAPITAL IN SEGMENTED VS. INTEGRATED MARKETS • The cost of equity capital (Ke) of a firm is the expected return on the firm’s stock that investors require. • This return is frequently estimated using the Capital Asset Pricing Model (CAPM): where bi= Cov(Ri ,RM) Var(RM) Ri = Rf + bi(RM – Rf) 17-6
  • 8. COST OF CAPITAL IN SEGMENTED VS. INTEGRATED MARKETS If capital markets are segmented, then investors can only invest domestically. This means that the market portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world portfolio. versus Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital. Ri = Rf + bi (RU.S. – Rf) U.S. Ri = Rf + bi (RW – Rf) W 17-7
  • 9. DOES THE COST OF CAPITAL DIFFER AMONG COUNTRIES? • There do appear to be differences in the cost of capital in different countries. • When markets are imperfect, international financing can lower the firm’s cost of capital. • One way to achieve this is to internationalize the firm’s ownership structure. 17-8
  • 10. 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. 17-9
  • 11. CROSS-BORDER LISTINGS OF STOCKS Cross-border listings of stocks benefit a company in the following ways. 1. The company can expand its potential investor base, which will lead to a higher stock price and lower cost of capital. 2. Cross-listing creates a secondary market for the company’s shares, which facilitates raising new capital in foreign markets. 3. Cross-listing can enhance the liquidity of the company’s stock. 4. Cross-listing enhances the visibility of the company’s name and its products in foreign marketplaces. 17-10
  • 12. CROSS-BORDER LISTINGS OF STOCKS Cross-border listings of stocks do carry costs. 1. It can be costly to meet the disclosure and listing requirements imposed by the foreign exchange and regulatory authorities. 2. Once a company’s stock is traded in overseas markets, there can be volatility spillover from these markets. 3. Once a company’s stock is make available to foreigners, they might acquire a controlling interest and challenge the domestic control of the company. 17-11
  • 13. CROSS-BORDER LISTINGS OF STOCKS On average, cross-border listings of stocks appears to be a profitable decision. The benefits outweigh the costs. 17-12
  • 14. THE EFFECT OF FOREIGN EQUITY OWNERSH RESTRICTIONS • While companies have incentives to internationalize their ownership structure to lower the cost of capital and increase market share, they may be concerned with the possible loss of corporate control to foreigners. • In some countries, there are legal restrictions on the percentage of a firm that foreigners can own. • These restrictions are imposed as a means of ensuring domestic control of local firms. 17-13
  • 15. PRICING-TO-MARKET PHENOMENON • Suppose foreigners, if allowed, would like to buy 30 percent of a Korean firm. • But they are constrained by ownership constraints imposed on foreigners to purchase at most 20 percent. • Because this constraint is effective in limiting desired foreign ownership, foreign and domestic investors many face different market share prices. • This dual pricing is the pricing-to-market phenomenon. 17-14
  • 16. ASSET PRICING UNDER FOREIGN OWNERSHIP RESTRICTIONS • An interesting outcome is that the firm’s cost of capital depends on which investors, domestic or foreign, supply capital. • The implication is that a firm can reduce its cost of capital by internationalizing its ownership structure. 17-15
  • 17. THE FINANCIAL STRUCTURE OF SUBSIDIARIES. • There are three different approaches to determining the subsidiary’s financial structure. 1. Conform to the parent company's norm. 2. Conform to the local norm of the country where the subsidiary operates. 3. Vary judiciously to capitalize on opportunities to lower taxes, reduce financing costs and risk, and take advantage of various market imperfections. 17-16
  • 18. THE FINANCIAL STRUCTURE OF SUBSIDIARIES. • In addition to taxes, political risk should be given due consideration in the choice of a subsidiary’s financial structure. 17-17