CHAPTER 14 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS.

CHAPTER 14CHAPTER 14

THE COST OF THE COST OF CAPITAL FOR CAPITAL FOR

FOREIGN FOREIGN INVESTMENTSINVESTMENTS

CHAPTER OVERVIEW:CHAPTER OVERVIEW:

I.I. THE COST OF EQUITY CAPITALTHE COST OF EQUITY CAPITAL

II.II. THE WEIGHTED AVERAGE COST THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN OF CAPITAL FOR FOREIGN PROJECTSPROJECTS

III.III. THE ALL-EQUITY COST OF THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS

IV.IV. DISCOUNT RATESDISCOUNT RATES

V.V. ESTABLISHING A WORLDWIDE ESTABLISHING A WORLDWIDE CAPITAL STRUCTURECAPITAL STRUCTURE

I. THE COST OF EQUITY I. THE COST OF EQUITY CAPITALCAPITAL

A.A. DefinitionDefinition

1. the minimum (required) rate of return1. the minimum (required) rate of return

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 cash 2. used to value future equity cash flows flows

3. determines common stock price3. determines common stock price

THE COST OF EQUITY THE COST OF EQUITY CAPITALCAPITAL

B.B. Capital Asset Pricing ModelCapital Asset Pricing Model

rrii = r = rff + + ii ( r ( rmm - r - rff ) )where rwhere rii = the equity required rate = the equity required rate

rrf f = the risk free return rate= the risk free return rate

ii= Cov(r= Cov(rmm, r, rii)/ )/ 22 r rm m where where

THE COST OF EQUITY THE COST OF EQUITY CAPITALCAPITAL

Cov(rCov(rmm, r, rii) is the covariance between asset ) is the covariance between asset

and market returns and and market returns and 22 r rmm , the variance , the variance

of market returns.of market returns.

II.II. THE WEIGHTED AVERAGE COST THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS OF CAPITAL FOR FOREIGN PROJECTS

II.II.THE WEIGHTED AVERAGE COST OF THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS

A.A. Weighted Average Cost of Capital Weighted 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

kke e = the equity cost of capital= the equity cost of capital

THE WEIGHTED AVERAGE COST OF THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS CAPITAL FOR FOREIGN PROJECTS

kk0 0 is used as the discount rate in the is 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 be b. Calculating WACC, weights must be

marginal reflecting future debtmarginal reflecting future debt

structure.structure.

THE WEIGHTED AVERAGE COST OF THE 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 + E I = P + E ff + D + D ff

wherewhere I = require subsidiary I = require subsidiary

financingfinancing

P = dollars by parentP = dollars by parent

E E ff = subsidiary’s retained = subsidiary’s retained

earnings earnings

D D ff = dollars from debt = dollars from debt


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.

kkss = k = ke e (1-T)(1-T)


c. Local Currency Debt (rc. Local Currency Debt (rff))

after-tax dollar cost of borrowingafter-tax dollar cost of borrowing

locallylocally


C. Computing WACC(kC. Computing WACC(k11))

kk1 1 = k= k0 0 - a(k- a(ke e -- kkss) - b[ i) - b[ idd(1-t) - i(1-t) - if f ] ]



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 discount 2. Solution: Use all equity discount raterate

3. To calculate:3. To calculate:

kk** = r = rff + + **( r( rmm - r - rff ) )

THE ALL-EQUITY COST OF THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS

4. 4. ** is the all-equity beta associated withis the all-equity beta associated with

the unleveraged cash flows.the unleveraged cash flows.

THE ALL-EQUITY COST OF THE 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

EDte

/)1(1*

IV.IV. DISCOUNT RATES FOR DISCOUNT 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 domestic less correlated with domestic

markets.markets.

DISCOUNT RATES FOR FOREIGN DISCOUNT RATES FOR FOREIGN PROJECTSPROJECTS

3. Paradox: LDCs have greater political3. Paradox: LDCs have greater political

risk but offer higher probability of risk but offer higher probability of

diversification benefits.diversification benefits.


B.B. Key Issues in Estimating Foreign Key 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


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 base Which is the relevant base portfolio to use?portfolio to use?

c.c. Should the market risk premium Should the market risk premium bebe

based on U.S. or local market?based on U.S. or local market?


2.2. Proxy CompaniesProxy Companies

a. Most desirable to use local a. Most desirable to use local firms firms

b. Alternative:b. Alternative:

find a proxy industry in the find a proxy industry in the local market local market


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 b. If not, domestic portfolio is bestbest


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.

V.V. ESTABLISHING AWORLD ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE WIDE CAPITAL STRUCTURE

V.V. ESTABLISHING A WORLDWIDEESTABLISHING A WORLDWIDE

CAPITAL STRUCTURECAPITAL STRUCTURE

A.A. MNC Advantage:MNC Advantage:

uses more debt due to uses more debt due to

diversificationdiversification

ESTABLISHING AWORLD WIDE ESTABLISHING 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.

CHAPTER 14 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS.

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