 # International Cost of Capital

## Presentation on theme: "International Cost of Capital"— Presentation transcript:

International Cost of Capital
(or chapter 11)

Agenda Weighted average cost of capital?
How to find international cost of equity? Market liquidity/segmentation & cost of capital? MNE vs. domestic counterpart WACC?

Weighted Average Cost of Capital
kWACC = weighted average cost of capital, WACC ke = risk adjusted cost of equity kd = before-tax cost of debt t = tax rate E = market value of equity D = market value of debt V = market value of firm (D+E)

International Cost of Equity
How to estimate? Many approaches: World CAPM (W. Sharpe). Segmented/Integrated CAPM (G. Bekaert & C. Harvey). Goldman Sachs - integrated. A.Damodaran’s method.

World CAPM Intuition: required rate of return depends on how investment contributes to volatility of well diversified portfolio. Expected return (in US\$) on investment = risk-free rate + b x world risk premium. Beta (b) measured relative to “world” portfolio. What is beta? Shows degree of “co-movement” Model assumption: perfect market integration. OK for developed markets (if allow risk to vary through time). Gives unreliable results in smaller/illiquid developed markets. Fails in emerging markets.

Source: Cam Harvey’s web site @ http://www.fuqua.duke.edu
World CAPM Failure Wrong risk / return relation !! Source: Cam Harvey’s web

Segmented/Integrated CAPM
CAPM assumes perfect integration. Markets oftentimes aren’t! STEPS Estimate world beta & expected return = world CC = risk-free + bW x world risk premium. Estimate local beta & expected return = local CC = local risk-free + bL x local risk premium. Put two in common currency terms. Add up two components: CC = w * [world CC] + (1-w) * [local CC] Weight w, determined by proxies for degree of integration: size of international trade & [equity market capitalization/GDP] Downside: appropriate for countries w/ equity markets.

Goldman Sachs-Integrated*

Source: Ibbotson Associates
Equity Risk Premium Source: Ibbotson Associates

Source: Ibbotson Associates

Cost of Equity & Debt: CAPM example
Cost of equity: calculate using Capital Asset Pricing Model (CAPM) Where ke = expected rate of return on equity krf = risk free rate on bonds km = expected rate of return on market β = coefficient of firm’s systematic risk Cost of debt: analyze proportions of various debt & their associated interest rates & calculate before- & after-tax weighted average cost of debt.

CAPM example A company headquartered in US
Use US as base for market & equity risk calculation kWACC = weighted average cost of capital ke = Cost of equity is 17% kd = Before-tax cost of debt is 8% t = tax rate of 35% E/V = equity-to-value ratio 60% D/V = debt-to-value ratio 40%

Market Liquidity & Segmentation
Market liquidity: degree to which firm can issue new securities without depressing existing market prices. Market illiquidity & segmentation influence marginal cost of capital Market Segmentation: claims w/ same expected return & risk class have different rates of return even after accounting for forex & political risks. Caused by: Asymmetric information High transaction costs Corporate governance practices Regulatory barriers

Liquidity/Segmentation & MCC*
Budget (\$million) Marginal cost of capital & Marginal rate of return (%) 10 20 30 40 50 60 20% 15% 13% 10% MNE from illiquid & segmented market MNE from illiquid market Domestic MRR MCCF kF MCCU kU kD MCCD * Marginal Cost of Capital

MNE vs. domestic WACC Empirical studies have found that:
MNE has lower debt/equity ratio MNE has higher systematic risk! Hidden Actions of Managers (Agency Costs) Asymmetric (Hidden) Information Political Risk Forex Risk So: MNE WACC could be > WACC domestic. But: MNE tend to be mature firms that follow pecking order i.e. they use internal cash Debt & rarely new equity Why? Equity is information sensitive!!!

Is MNE WACC < domestic WACC?
Theory: MNE should have low cost & abundant capital. Budget (\$m) Marginal cost of capital (%) 100 140 300 350 400 15% 10% 5% 20% Large Set of Projects MCCDC Small Set of Projects MRRMNE MRRDC MCCMNE

But…a few unsettling facts…
[ kWACC = ke Equity Value + kd ( 1 – tax ) Debt ] MNEWACC >?< DomesticWACC Required cost of equity higher for MNE (Political risk, forex risk, high agency costs). => At high levels of capital budget, MNE has lower cost of capital. MNE: lower cost of debt => lower cost capital. MNE: lower debt/capital ratio => higher cost capital.

Things to remember… Weighted average cost of capital?
How to find international cost of equity? Market liquidity/segmentation & cost of capital? MNE vs. domestic WACC?