2 Agenda Weighted average cost of capital? How to find international cost of equity?Market liquidity/segmentation & cost of capital?MNE vs. domestic counterpart WACC?
3 Weighted Average Cost of Capital kWACC = weighted average cost of capital, WACCke = risk adjusted cost of equitykd = before-tax cost of debtt = tax rateE = market value of equityD = market value of debtV = market value of firm (D+E)
4 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.
5 World CAPMIntuition: required rate of return depends on how investment contributes to volatility of well diversified portfolio.Expected return (in US$) on investment= risk-free rate + b x world risk premium.Beta (b) measured relative to “world” portfolio.What is beta?Shows degree of “co-movement”Model assumption: perfect market integration.OK for developed markets (if allow risk to vary through time).Gives unreliable results in smaller/illiquid developed markets.Fails in emerging markets.
6 Source: Cam Harvey’s web site @ http://www.fuqua.duke.edu World CAPM FailureWrong risk / return relation !!Source: Cam Harvey’s web
7 Segmented/Integrated CAPM CAPM assumes perfect integration. Markets oftentimes aren’t!STEPSEstimate world beta & expected return = world CC= risk-free + bW x world risk premium.Estimate local beta & expected return = local CC= local risk-free + bL x local risk premium.Put two in common currency terms.Add up two components:CC = w * [world CC] + (1-w) * [local CC]Weight w, determined by proxies for degree of integration: size of international trade & [equity market capitalization/GDP]Downside: appropriate for countries w/ equity markets.
8 Goldman Sachs-Integrated* CAPM gives low expected return, so add sovereign yield spread.Idea: Default risk premium correlated w/ equity risk premium.Sovereign yield spread: yield on US$ bond a country offers vs. US T-bond of same maturity.Spread reflects “country risk”STEPSEstimate market beta on S&P 500.Get beta times historical US equity premium.Add sovereign yield spread plus risk free to get equity risk premium.Useful if you have sovereign yield spread.Model used by McKinsey, Salomon & others.*J.Mariscal & R. Lee, “Valuation of Mexican Stocks: An extension of the capitalasset pricing model to emerging markets”, Goldman Sachs, 1993.
11 Cost of Equity & Debt: CAPM example Cost of equity: calculate using Capital Asset Pricing Model (CAPM)Whereke = expected rate of return on equitykrf = risk free rate on bondskm = expected rate of return on marketβ = coefficient of firm’s systematic riskCost of debt: analyze proportions of various debt & their associated interest rates & calculate before- & after-tax weighted average cost of debt.
12 CAPM example A company headquartered in US Use US as base for market & equity risk calculationkWACC = weighted average cost of capitalke = 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%
13 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 capitalMarket Segmentation: claims w/ same expected return & risk class have different rates of return even after accounting for forex & political risks.Caused by:Asymmetric informationHigh transaction costsCorporate governance practicesRegulatory barriers
14 Liquidity/Segmentation & MCC* Budget($million)Marginal cost of capital &Marginal rate of return(%)10203040506020%15%13%10%MNE from illiquid & segmented marketMNE from illiquid marketDomesticMRRMCCFkFMCCUkUkDMCCD* Marginal Cost of Capital
15 MNE vs. domestic WACC Empirical studies have found that: MNE has lower debt/equity ratioMNE has higher systematic risk!Hidden Actions of Managers (Agency Costs)Asymmetric (Hidden) InformationPolitical RiskForex RiskSo: MNE WACC could be > WACC domestic.But: MNE tend to be mature firms that follow pecking orderi.e. they useinternal cashDebt& rarely new equityWhy? Equity is information sensitive!!!
16 Is MNE WACC < domestic WACC? Theory: MNE should have low cost & abundant capital.Budget($m)Marginal cost of capital (%)10014030035040015%10%5%20%LargeSet of ProjectsMCCDCSmallSet of ProjectsMRRMNEMRRDCMCCMNE
17 But…a few unsettling facts… [kWACC = keEquityValue+ kd ( 1 – tax )Debt]MNEWACC >?< DomesticWACCRequired 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.
18 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?