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CHAPTER 14 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS.

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Presentation on theme: "CHAPTER 14 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS."— Presentation transcript:

1 CHAPTER 14 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS

2 CHAPTER OVERVIEW: I.THE COST OF EQUITY CAPITAL II.THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS III.THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS IV.DISCOUNT RATES V.ESTABLISHING A WORLDWIDE CAPITAL STRUCTURE

3 I. THE COST OF EQUITY CAPITAL A.Definition 1. the minimum (required) rate of return necessary to induce investors to buy necessary to induce investors to buy or hold the firm’s stock. or hold the firm’s stock. 2. used to value future equity cash flows 3. determines common stock price

4 THE COST OF EQUITY CAPITAL B.Capital Asset Pricing Model r i = r f +  i ( r m - r f ) where r i = the equity required rate r f = the risk free return rate r f = the risk free return rate  i = Cov(r m, r i )/  2 r m where  i = Cov(r m, r i )/  2 r m where

5 THE COST OF EQUITY CAPITAL Cov(r m, r i ) is the covariance between asset and market returns and  2 r m, the variance of market returns.

6 II.THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS A.Weighted Average Cost of Capital (WACC = k 0 ) k 0 = (1-L) k e + L i d (1 - t) k 0 = (1-L) k e + L i d (1 - t) where L = the parent’s debt ratio i d (1 - t) = the after-tax debt cost i d (1 - t) = the after-tax debt cost k e = the equity cost of capital k e = the equity cost of capital

7 THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS k 0 is used as the discount rate in the k 0 is used as the discount rate in the calculation of Net Present Value. 2.Two Caveats a. Weights must be a proportion using market, not book value. market, not book value. b. Calculating WACC, weights must be marginal reflecting future debt marginal reflecting future debt structure. structure.

8 THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS B.Costing Various Sources of Funds 1.Components of a New Investment (I) I = P + E f + D f whereI = require subsidiary financing P = dollars by parent E f = subsidiary’s retained earnings E f = subsidiary’s retained earnings D f = dollars from debt D f = dollars from debt

9 THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS 2. First compute each component a.Parent’s company funds (k 0 ) required rate equal to the marginal cost of capital b.Retained Earnings (k s ) a function of dividends, withholding taxes, tax deferral, and transfer costs. k s = k e (1-T) k s = k e (1-T)

10 THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS c. Local Currency Debt (r f ) after-tax dollar cost of borrowing locally

11 THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS C. Computing WACC(k 1 ) k 1 = k 0 - a(k e - k s ) - b[ i d (1-t) - i f ] k 1 = k 0 - a(k e - k s ) - b[ i d (1-t) - i f ]

12 III.THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS A.WACC sometimes awkward 1. To go from the parent to the project 2. Solution: Use all equity discount rate 3. To calculate: k * = r f +  * ( r m - r f ) k * = r f +  * ( r m - r f )

13 THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS 4.  * is the all-equity beta associated with the unleveraged cash flows. the unleveraged cash flows.

14 THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS 5. Unlevering beta obtained by where B * = the firm’s stock price beta D/E = the debt to equity ratio D/E = the debt to equity ratio t = the firm’s marginal tax t = the firm’s marginal tax

15 IV.DISCOUNT RATES FOR FOREIGN PROJECTS IV.DISCOUNT RATES FOR FOREIGN PROJECTS A.Systematic Risk 1. Not diversifiable 2. Foreign projects in non- synchronous economies should be less correlated with domestic markets. less correlated with domestic markets.

16 DISCOUNT RATES FOR FOREIGN PROJECTS 3. Paradox: LDCs have greater political risk but offer higher probability of risk but offer higher probability of diversification benefits. diversification benefits.

17 DISCOUNT RATES FOR FOREIGN PROJECTS B.Key Issues in Estimating Foreign Project Betas -find firms publicly traded that share similar risk characteristics -use the average beta as a proxy

18 DISCOUNT RATES FOR FOREIGN PROJECTS 1.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?

19 DISCOUNT RATES FOR FOREIGN PROJECTS 2.Proxy Companies a. Most desirable to use local firms b. Alternative: find a proxy industry in the local market find a proxy industry in the local market

20 DISCOUNT RATES FOR FOREIGN PROJECTS 3.Relevant Base (Market) Portfolio a. If capital markets are globally integrated, choose world mkt. integrated, choose world mkt. b. If not, domestic portfolio is best

21 DISCOUNT RATES FOR FOREIGN PROJECTS 4. Relevant Market Risk Premium a. Use the U.S. portfolio b. Foreign project: should have no higher than domestic risk no higher than domestic risk and cost of capital. and cost of capital.

22 V.ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE V.ESTABLISHING A WORLDWIDE CAPITAL STRUCTURE A.MNC Advantage: uses more debt due to diversification

23 ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE B.What is proper capital structure? 1.Borrowing in local currency helps to reduce exchange rate risk 2.Allow subsidiary to exceed parent capitalization norm if local mkt. has lower costs.


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