THE COST OF CAPITAL FOR FOREIGN INVESTMENTS
CHAPTER 14THE COST OF CAPITAL FOR FOREIGN INVESTMENTSCHAPTER OVERVIEW:I.THE COST OF EQUITY CAPITALII.THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTSIII.THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTSIV.DISCOUNT RATESV.ESTABLISHING A WORLDWIDE CAPITAL STRUCTUREI. THE COST OF EQUITY CAPITALA.Definition1. the minimum (required) rate of return necessary to induce investors to buy or hold the firms stock.2. used to value future equity cash flows3. determines common stock priceTHE COST OF EQUITY CAPITALB.Capital Asset Pricing Modelri = rf + i ( rm - rf )where ri = the equity required rate rf = the risk free return rate i= Cov(rm, ri)/ 2 rm where THE COST OF EQUITY CAPITALCov(rm, ri) is the covariance between asset and market returns and 2 rm , the variance of market returns.II.THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS II.THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTSA.Weighted Average Cost of Capital (WACC = k0) k0 = (1-L) ke + L id (1 - t)where L = the parents debt ratio id (1 - t) = the after-tax debt cost ke = the equity cost of capitalTHE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS k0 is used as the discount rate in the calculation of Net Present Value.2.Two Caveatsa. Weights must be a proportion using market, not book value.b. Calculating WACC, weights must be marginal reflecting future debt structure.THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTSB.Costing Various Sources of Funds1.Components of a New Investment (I)I = P + E f + D fwhereI = require subsidiary financingP = dollars by parent E f = subsidiarys retained earnings D f = dollars from debtTHE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS2. First compute each componenta.Parents company funds (k0)required rate equal to the marginalcost of capitalb.Retained Earnings (ks)a function of dividends, withholding taxes, tax deferral,and transfer costs. ks = ke (1-T)THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTSc. Local Currency Debt (rf)after-tax dollar cost of borrowinglocally
THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTSC. Computing WACC(k1)
k1 = k0 - a(ke - ks) - b[ id(1-t) - if ]III.THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTSIII.THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTSA.WACC sometimes awkward1. To go from the parent to the project2. Solution: Use all equity discount rate3. To calculate: k* = rf + *( rm - rf )THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS4. * is the all-equity beta associated with the unleveraged cash flows.THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS5. Unlevering beta obtained by
where B* = the firms stock price beta D/E = the debt to equity ratio t = the firms marginal tax
IV.DISCOUNT RATES FOR FOREIGN PROJECTSIV.DISCOUNT RATES FOR FOREIGNPROJECTSA.Systematic Risk1. Not diversifiable2. Foreign projects in non- synchronous economies should be less correlated with domestic markets.DISCOUNT RATES FOR FOREIGN PROJECTS3. Paradox: LDCs have greater political risk but offer higher probability of diversification benefits.DISCOUNT RATES FOR FOREIGN PROJECTSB.Key Issues in Estimating Foreign Project Betas-find firms publicly traded that share similar risk characteristics-use the average beta as a proxyDISCOUNT RATES FOR FOREIGN PROJECTS1.Three Issues:a.Should proxies be U.S. or localcompanies?b.Which is the relevant base portfolio to use?c.Should the market risk premium bebased on U.S. or local market?DISCOUNT RATES FOR FOREIGN PROJECTS2.Proxy Companiesa. Most desirable to use local firmsb. Alternative: find a proxy industry in the local marketDISCOUNT RATES FOR FOREIGN PROJECTS3.Relevant Base (Market) Portfolioa. If capital markets are globally integrated, choose world mkt.b. If not, domestic portfolio is bestDISCOUNT RATES FOR FOREIGN PROJECTS4. Relevant Market Risk Premiuma. Use the U.S. portfoliob. Foreign project: should have no higher than domestic risk and cost of capital.
V.ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE
V.ESTABLISHING A WORLDWIDECAPITAL STRUCTUREA.MNC Advantage:uses more debt due to diversificationESTABLISHING AWORLD WIDE CAPITAL STRUCTUREB.What is proper capital structure?1.Borrowing in local currency helpsto reduce exchange rate risk2.Allow subsidiary to exceed parentcapitalization norm if local mkt.has lower costs.
