The document discusses the cost of capital, which is essential for valuing investments and creating value within a firm. It explains how estimating the cost of capital is complex and considers factors like the cost of equity and the weighted average cost of capital (WACC), particularly for foreign projects. Additionally, it highlights the differences in the cost of capital across countries and the impact of taxes on financing costs.

1. SUNDAR B. N.
ASSISTANT PROFESSOR
THE COST OF CAPITAL
FOR FOREIGN
INVESTMENTS

2. 1. Introduction
The cost of capital is the cost of using the funds of
creditors and owners.
Creating value requires investing in capital projects that
provide a return greater than the project’s cost of capital.
When we view the firm as a whole, the firm creates value
when it provides a return greater than its cost of
capital.
Estimating the cost of capital is challenging.
We must estimate it because it cannot be observed.
We must make a number of assumptions.
For a given project, a firm’s financial manager must
estimate its cost of capital. 2

3. 2. Cost of capital
The cost of capital is the rate of return that the suppliers
of capital—bondholders and owners—require as
compensation for their contributions of capital.
This cost reflects the opportunity costs of the
suppliers of capital.
The cost of capital is a marginal cost: the cost of raising
additional capital.
The weighted average cost of capital (WACC) is the cost
of raising additional capital, with the weights
representing the proportion of each source of
financing that is used.
Also known as the marginal cost of capital (MCC). 3

4. I. THE COST OF EQUITY
CAPITAL
A. Definition
1. the minimum (required) rate of return
necessary to induce investors to buy
or hold the firm’s stock.
2. used to value future equity cash
flows
3. determines common stock price

5. THE COST OF EQUITY
CAPITAL
B. Capital Asset Pricing Model
ri = rf + i ( rm - rf )
where ri = the equity required rate
rf = the risk free return rate
i= Cov(rm, ri)/ 2 rm where
Cov(rm, ri) is the covariance between
asset and market returns and 2 rm ,
the variance of market returns.

6. II. THE WEIGHTED AVERAGE COST
OF CAPITAL FOR FOREIGN PROJECTS
A. Weighted Average Cost of Capital
(WACC = k0)
k0 = (1-L) ke + L id (1 - t)
where L = the parent’s debt ratio
id (1 - t) = the after-tax debt cost
ke = the equity cost of capital
k0 is used as the discount rate in the
calculation of Net Present Value.

7. THE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTS
Two Caveats
a. Weights must be a proportion using
market, not book value.
b. Calculating WACC, weights must be
marginal reflecting future debt
structure.

8. 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.
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9. Taxes and the Cost of capital
Interest on debt is tax deductible; therefore, the
cost of debt must be adjusted to reflect this
deductibility.
We multiple the before-tax cost of debt (rd) by the factor
(1 – t), with t as the marginal tax rate.
Thus, rd × (1  t) is the after-tax cost of debt.
Payments to owners are not tax deductible, so the
required rate of return on equity (whether
preferred or common) is the cost of capital.
Copyright © 2013 CFA Institute 9