chapter 14 the cost of capital for foreign investments
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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
THE WEIGHTED AVERAGE COST OF THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
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)
THE WEIGHTED AVERAGE COST OF THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
c. Local Currency Debt (rc. Local Currency Debt (rff))
after-tax dollar cost of borrowingafter-tax dollar cost of borrowing
locallylocally
THE WEIGHTED AVERAGE COST OF THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
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 ] ]
III.III. THE ALL-EQUITY COST OF THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
III.III. THE ALL-EQUITY COST OF THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTSCAPITAL FOR FOREIGN PROJECTS
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.
DISCOUNT RATES FOR FOREIGN DISCOUNT RATES FOR FOREIGN PROJECTSPROJECTS
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
DISCOUNT RATES FOR FOREIGN DISCOUNT RATES FOR FOREIGN PROJECTSPROJECTS
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?
DISCOUNT RATES FOR FOREIGN DISCOUNT RATES FOR FOREIGN PROJECTSPROJECTS
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
DISCOUNT RATES FOR FOREIGN DISCOUNT RATES FOR FOREIGN PROJECTSPROJECTS
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
DISCOUNT RATES FOR FOREIGN DISCOUNT RATES FOR FOREIGN PROJECTSPROJECTS
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.