Presentation on theme: "THE COST OF CAPITAL FOR FOREIGN INVESTMENTS"— Presentation transcript:
1THE COST OF CAPITAL FOR FOREIGN INVESTMENTS CHAPTER 14THE COST OF CAPITAL FOR FOREIGN INVESTMENTS
2CHAPTER OVERVIEW: I. THE COST OF EQUITY CAPITAL II. THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTSIII. THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTSIV. DISCOUNT RATESV. ESTABLISHING A WORLDWIDE CAPITAL STRUCTURE
3I. THE COST OF EQUITY CAPITAL A. Definition1. the minimum (required) rate of returnnecessary to induce investors to buyor hold the firm’s stock.2. used to value future equity cash flows3. determines common stock price
4THE COST OF EQUITY CAPITAL B. Capital Asset Pricing Modelri = rf + i ( rm - rf )where ri = the equity required raterf = the risk free return ratei= Cov(rm, ri)/ 2 rm where
5THE COST OF EQUITY CAPITAL Cov(rm, ri) is the covariance between asset and market returns and 2 rm , the variance of market returns.
6II. 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 ratioid (1 - t) = the after-tax debt costke = the equity cost of capital
7THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS k0 is used as the discount rate in thecalculation of Net Present Value.2. Two Caveatsa. Weights must be a proportion usingmarket, not book value.b. Calculating WACC, weights must bemarginal reflecting future debtstructure.
8THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS B. Costing Various Sources of Funds1. Components of a New Investment (I)I = P + E f + D fwhere I = require subsidiary financingP = dollars by parentE f = subsidiary’s retained earningsD f = dollars from debt
9THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS 2. First compute each componenta. Parent’s 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)
10THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS c. Local Currency Debt (rf)after-tax dollar cost of borrowinglocally
11THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS C. Computing WACC(k1)k1 = k0 - a(ke - ks) - b[ id(1-t) - if ]
12III. THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS A. WACC sometimes awkward1. To go from the parent to the project2. Solution: Use all equity discount rate3. To calculate:k* = rf + *( rm - rf )
13THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS 4. * is the all-equity beta associated withthe unleveraged cash flows.
14THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS 5. Unlevering beta obtained bywhere B* = the firm’s stock price betaD/E = the debt to equity ratiot = the firm’s marginal tax
15IV. DISCOUNT RATES FOR FOREIGN PROJECTS A. Systematic Risk1. Not diversifiable2. Foreign projects in non synchronous economies should beless correlated with domestic markets.
16DISCOUNT RATES FOR FOREIGN PROJECTS 3. Paradox: LDCs have greater politicalrisk but offer higher probability ofdiversification benefits.
17DISCOUNT RATES FOR FOREIGN PROJECTS B. Key Issues in Estimating Foreign Project Betas-find firms publicly traded that sharesimilar risk characteristics-use the average beta as a proxy
18DISCOUNT RATES FOR FOREIGN PROJECTS 1. 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?
19DISCOUNT RATES FOR FOREIGN PROJECTS 2. Proxy Companiesa. Most desirable to use local firmsb. Alternative:find a proxy industry in the local market
20DISCOUNT RATES FOR FOREIGN PROJECTS 3. Relevant Base (Market) Portfolioa. If capital markets are globallyintegrated, choose world mkt.b. If not, domestic portfolio is best
21DISCOUNT RATES FOR FOREIGN PROJECTS 4. Relevant Market Risk Premiuma. Use the U.S. portfoliob. Foreign project: should haveno higher than domestic riskand cost of capital.
22V. ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE A. MNC Advantage:uses more debt due to diversification
23ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE B. 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.