Multinational Financial Management Alan Shapiro 7th Edition J.Wiley & Sons Power Points by Joseph F Greco, Ph.D California State University, Fullerton CHAPTER 14 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS CHAPTER OVERVIEW: I THE COST OF EQUITY CAPITAL II THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS III DISCOUNT RATES FOR FOREIGN INVESTMENTS IV THE COST OF DEBT CAPITAL V ESTABLISHING A WORLDWIDE CAPITAL STRUCTURE I THE COST OF EQUITY CAPITAL A Definition the minimum (required) rate of return necessary to induce investors to buy or hold the firm’s stock used to value future equity cash flows determines common stock price THE COST OF EQUITY CAPITAL B Capital Asset Pricing Model ri = rf where +  i ( rm - r f ) ri = the equity required rate rf = the risk free return rate i= Cov(rm, ri)/ 2 rm where THE COST OF EQUITY CAPITAL Cov(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 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 THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS k0 is used as the discount rate in the calculation of Net Present Value Two Caveats a Weights must be a proportion using market, not book value b Calculating WACC, weights must be marginal reflecting future debt structure III DISCOUNT RATES FOR FOREIGN INVESTMENTS III DISCOUNT RATES AND FOREIGN PROJECTS A Systematic Risk Not diversifiable Foreign projects in non-synchronous economies should be less correlated with domestic markets DISCOUNT RATES FOR FOREIGN INVESTMENTS Paradox: LDCs have greater political risk but offer higher probability of diversification benefits 10 DISCOUNT RATES FOR FOREIGN INVESTMENTS B Key Issues in Estimating Foreign Project Betas -find firms publicly traded that share similar risk characteristics -use the average beta as a proxy 11 DISCOUNT RATES FOR FOREIGN INVESTMENTS Three Issues: a Should proxies be U.S or local companies? b Which is the relevant base portfolio to use? c Should the market risk premium be based on U.S or local market? 12 DISCOUNT RATES FOR FOREIGN INVESTMENTS local Proxy Companies a Most desirable to use firms b Alternative: find a proxy industry in the local market 13 DISCOUNT RATES FOR FOREIGN INVESTMENTS Relevant Base (Market) Portfolio a If capital markets are globally integrated, choose world mkt b If not, domestic portfolio is best 14 DISCOUNT RATES FOR FOREIGN INVESTMENTS Relevant Market Risk Premium a Use the U.S portfolio b Foreign project: should have no higher than domestic risk and cost of capital 15 IV THE COST OF DEBT CAPITAL The use of sovereign risk premium is appropriate for estimating the cost of debt associated with a foreign project 16 V ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE V MNC ADVANTAGE IN ESTABLISHING A WORLDWIDE CAPITAL STRUCTURE: It uses more debt due to diversification 17 ESTABLISHING A WORLD WIDE CAPITAL STRUCTURE A What is proper capital structure? Borrowing in local currency helps to reduce exchange rate risk Allow subsidiary to exceed parent capitalization norm if local mkt has lower costs 18