International Finance Chapters 16 and 17 International Capital Structure and the Cost of Capital (16) International Capital Budgeting (17)

Cost of Capital The minimum rate of return which a project must generate in order to cover the “expectations” of those who have contributed capital (financed) to the firm. Hurdle Rate in accepting/rejecting projects.

Cost of Capital and Global Firms The cost of capital for global firms may be affected through two distinct channels: Global operations may make the firm more or less risky and thus affect the “expected” returns of capital contributors. Financing the firm globally (taking on a global capital structure), especially in lower financing cost markets, may affect the firm’s overall cost of capital.

Globalizing the Firm’s Markets As a firm moves from a domestic setting to a global setting, its cost of capital is likely to change as capital contributors view the impact of the firm’s global expansion on the “risk” level of the firm. Is the firm taking on more risk? Is the firm taking on less risk, or making itself less risky as a result of its global expansion?

Political Risk and Cost of Capital Once a global company has assessed the political risk associated with a particular country, it can then adjust its “project cost of capital” to take into account this assessment. Project (country) cost of capital may be higher than the firm’s purely domestic cost of capital. Depends upon the non-domestic environment in which the firm engages.

Globalizing the Firm’s Capital Structure As global firms take on a global capital structure, the next issue is to what extent does this global capital structure affect the global firm’s cost of capital? Can it source in overseas financial markets where financing costs are lower than back home? This will lower the firm’s overall cost of capital!

Estimating Cost of Capital As noted, the cost of capital is the minimum rate of return an investment project must generate in order to pay its financing costs. For a levered (using debt) firm, the financing costs can be represented by the weighted average cost of capital.

Weighted Average Cost of Capital K = (1 – )Kl + (1 – t)i Where K = weighted average cost of capital Kl = cost of equity capital for a levered firm i = pretax cost of debt  = debt to total market value ratio t = marginal corporate income tax rate

The Firm’s Investment Decision and the Cost of Capital A firm that can reduce its cost of capital (k) will increase the profitable capital expenditures that the firm can take on (and can increase the wealth of the shareholders). Globalizing the firm may be one such policy. Markets Capital Structure IRR cost of capital (%) Klocal Ilocal Kglobal Iglobal Investment ($)

Does the Cost of Funds Differ among Countries? Answer: Yes! There are differences in the cost of funds among countries. Japan versus the rest of the world today (foreign bond rates). Smaller and less liquid financial markets have higher financing costs. Segmented markets carry higher financing costs. Implications for Global Firms: Global firms may be able to lower their overall cost of capital through a strategy of globalizing the firm’s capital structure.

Corporate Bond Rates: Large, Liquid Markets, June 19, 2003 Country Long Term Corporate Bonds Australia 6.75% U.K. 5.93% Canada 6/15% Japan 1.88% Switzerland 2.67% U.S. 6.09% Euro Area 4.17% Source: The Economist Magazine

10 Year Government Bond Rates June 19, 2004 Variations among large liquid markets in rates. Japan the lowest! Upward trend since last year in these rates.

Less Liquid Financial Markets Definition: An illiquid market is characterized by small turnover. Difficulties in raising funds, especially large offerings. Market distortions associated with raising funds. Impacts on share prices and interest rates. A firm that must source its long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively higher cost of capital and will also face limited availability of such capital. Strategies need to be designed to allow firms to finance in more liquid markets.

Small Financial Markets Relatively small financial markets have difficulty in meeting the large financing needs of firms. Thus, financing costs are likely to be higher for firm’s financing under such conditions. Firms need to develop strategies to allow them to finance in larger international markets.

Short Term Interest Rates: Small, Less Liquid Markets, June 19, 2004 Country Short term interest rate (p.a.) China 2.85% India 4.41% Korea 3.90% Brazil 15.79% Mexico 6.54% South Africa 8.20% Hungary 11.50% Turkey 25.26% United States 1.45%

Segmented Financial Markets Capital markets become segmented because of such factors as excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, insider trading and other market imperfections. Consequence of a segmented market: the required rate of return on securities will be higher than the required rate of return on securities of comparable quality traded on other securities markets; thus, higher cost of capital for these markets! Firms in segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needs.

Firm Specific Influences on Financing Options Some firms because of their relatively small size, short history, and/or appeal may not be able to escape their domestic capital markets. If constrained to small, less liquid, and/or segmented domestic capital markets this will result in higher financing costs for these firms. may be constrained to their domestic capital market. These firms will be at a competitive disadvantage to others. These firms must design strategies to overcome their firm specific barriers to global markets.

Local Market versus Global Market Access Firm’s securities appeal only to domestic investors Firm’s securities appeal to international portfolio investors Firm-Specific Characteristics Local Market Access Global Market Access Market Liquidity or Size on Financing Costs Illiquid domestic securities market or small domestic market Higher financing costs Highly liquid and large markets with wide international participation Lower financing costs Market Segmentation on Firm’s Securities and Cost of Capital Segmented domestic securities market that prices shares according to domestic standards Access to global securities market that prices shares according to international standards

Strategies for Overcoming Small, Less Liquid and Segmented Markets Firms financing in small, less liquid, and/or segmented capital markets will do so at relatively higher costs. Higher interest rates. Lower prices for equities. What strategies can these firms use to escape these markets? Cross list equity on the world’s major stock exchanges (New York and London).

Cross Listing as a Strategy What can a firm hope to achieve through cross listing? Cross listing on major exchange will “force” the firm as it complies with listing requirements to increase its level of financial disclosure. Firm becomes more “transparent.” Management is more likely to manage in the best interest of shareholders. Corporate governance improves!

Impact of Cross Listing on Cost of Capital Cross listing which results in more stringent disclosure and better corporate governance, can result in lower financing costs. Share prices may rise as a result of cross listing in New York or London; i.e., positive revaluation of share price. Andrew Karolyi (1996) study: cross listing resulted in a reduction in the cost of equity capital of 114 basis points on average. Debt cost will probably also be favorably affected!

Cost of Capital Differences Robert McCauley and Steven Zimmer (1994) study offers a direct comparison of the cost of capital among four major countries: United States United Kingdom Japan Germany Conclusions: There are differences, although they may be narrowing.

Evidence on Cost of Capital Differences: After Tax Cost of Debt

Evidence on Cost of Capital Differences: Cost of Equity

Evidence on Cost of Capital Differences: After Tax Cost of Capital

Does Cost of Financing Differ Among Financing Options? Answer: Yes! Eurobond financing is typically lower than comparable domestic borrowing. Eurobonds are bearer bonds! Eurobonds have less regulation. Lowers the cost of issuing. Implications for Global Firms Global firms may be able to lower their overall cost of capital through a strategy of utilizing lower cost financing options (such as the euromarkets).

Do Firms in Different Countries have Different Costs of Capital? Answer: Historically, yes! Japan and German firms typically lower than U.S. and U.K. firms (1970s, 1980s and early 1990s) Why? Firms utilizing different capital structures (debt/equity ratios) Japan’s advantage: Low cost, long term debt. Germany’s advantage: Low cost, short term debt (bank loans). However, these costs differences tend to be narrowing! Probably due to the globalization of U.S. and U.K. firms.

Evidence on Cost of Capital Differences: Debt to Equity Ratios

Cost of Capital for Global versus Domestic Firms Question facing Global Firms: Is the weighted average cost of capital for a global firm higher or lower than for its domestic counterpart? The answer is not simple; it is a function of: The relative cost of equity The after-tax cost of debt The debt capital ratios

Empirical Evidence on Cost of Capital [ kWACC = ke Equity Value + kd ( 1 – tx ) Debt ] Is MNEwacc > or < Domesticwacc ? Other factors constant, the cost of equity required by investors appears to be higher for multinational firms than for domestic firms. A function of the countries in which the global firm is operating. Possible explanations are higher levels of political risk, foreign exchange risk, and higher agency costs of doing business in a multinational managerial environment. Probably not true for firms escaping small, less liquid and/or segmented financial markets! Indications are that MNEs have a lower average cost of debt (interest rates they pay) than domestic counterparts. Lower financing costs suggest MNEs have a lower cost of capital. Empirical studies indicate MNEs have a lower debt/capital ratio than domestic counterparts. Less use of lower cost debt suggests that MNEs may have a higher cost of capital.

Review of Capital Budgeting 1. Identify the SIZE and TIMING of all relevant cash flows on a time line. 2. Identify the RISKINESS of the cash flows to determine the appropriate discount rate (cost of capital). 3. Find NPV by discounting the cash flows at the appropriate discount rate (cost of capital). 4. Compare the value of competing cash flow streams at the same point in time.

International Capital Budgeting Capital budgeting for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Convert to U.S. dollars at the predicted exchange rate. 3. Calculate NPV using the U.S. cost of capital as a benchmark. Adjust U.S. cost of capital to account for political risk issues. 2

International Capital Budgeting Example – 600€ 200€ 1 500€ 2 300€ 3 € interest rate = 3% $ interest rate = 6% Cost of capital = 15% Is this a good investment from the perspective of the U.S. shareholders? € $.55265 S0($/€) = 2

International Capital Budgeting: Example $331.60 – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years CF0 = (€600)× S0($/€) = (€600)× = $331.60 € $.55265 2

International Capital Budgeting: Example $331.60 $113.70 – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years CF1 = (€200)×E[ S1($/€)] = E[ S1($/€)] can be found by using the interest rate differential (IFE): 1.03 1.06 E[S€(1)] =  S0($/€) 1.03 1.06 =  € $.55265 = $.5687/€ so CF1 = (€200)×($.5687/€) = $113.7 2

International Capital Budgeting: Example $331.60 $113.70 $292.60 – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years Similarly, CF2 = × S0($/€) (€500) = $292.6 1.03 1.06 × 2

International Capital Budgeting: Example $331.60 $113.70 $292.60 $180.70 – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years CF3 = × S0($/€) (€300) = $180.7 (1.03)3 (1.06)3 2

International Capital Budgeting Issues Estimating future spot rates for the purpose of converting foreign currency earnings to U.S. dollar earnings. Use parity model (IFE) to estimate future spot rate. Determining the appropriate cost of capital. Begin with home country cost of capital This will take into account the impact of a globalized capital structure on the firm’s home country cost of capital. Adjust home country cost of capital for the foreign environment’s political risk. Analyze the foreign project on this basis!