1. International Financial Management Vicentiu Covrig 1 International Capital Structure and the Cost of Capital International Capital Structure and the Cost of Capital (chapter 16)

2. International Financial Management Vicentiu Covrig 2 Cost of Capital 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 firm, the financing costs can be represented by the weighted average cost of capital. Where K = weighted average cost of capital K l = cost of equity capital for a levered firm i = pretax cost of debt = debt to total market value ratio  = tax rate

3. International Financial Management Vicentiu Covrig 3 The Firm’s Investment Decision and the Cost of Capital A firm that can reduce its cost of capital will increase the profitable capital expenditures that the firm can take on and increase the wealth of the shareholders. Internationalizing the firm’s cost of capital is one such policy. cost of capital (%) Investment ($) IRR K global K local I local I global

4. International Financial Management Vicentiu Covrig 4 Cost of Capital in Segmented vs. Integrated Markets The cost of equity capital (K e ) of a firm is the expected return on the firm’s stock that investors require. This return is frequently estimated using the Capital Asset Pricing Model (CAPM): where

5. International Financial Management Vicentiu Covrig 5 Cost of Capital in Segmented vs. Integrated Markets If capital markets are segmented, then investors can only invest domestically. This means that the market portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world portfolio. Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital. versus

6. International Financial Management Vicentiu Covrig 6 Example: Cost of capital for Nestle Nestle, is a the Swiss-based MNC that produces and distributes a variety of food products. R f =3.3%; R SZ =10%;  N-SZ =0.885; R W =11%;  N-W =0.585; Assume that Nestle pays 4% for it’s debt; has a debt/total capitalization ratio of 0.35 and pays a tax rate of 20%. Calculate the cost of equity capital for Nestle assuming the (i) Swiss market is segmented, and (ii) Swiss market is perfectly globally integrated Calculate Nestle’s WACC, considering the Swiss market is globally integrated.

7. International Financial Management Vicentiu Covrig 7 Exam type question Royal Dutch Petroleum, a large multinational corporation, has an equity market value of 100 billion dollars and a value of its outstanding debt estimated at 30 billion dollars. The equity beta for Royal Dutch, based on the world market index, is 1.1; the risk free rate is 3% and the expected return on the world market index is 10%. The corporate tax rate is 40% and the cost of debt capital is 6%. Calculate Royal Dutch’s weighted average cost of capital. Answer: The debt weight is 0.3 (30b./100b.) and the equity weight is 0.7. K l = Rf+beta*(Rw-Rf)=3%+1.1*(10%-3%)=10.7% WACC= 0.7*10.7%+0.3*(1-0.4)*6%= 8.57%

8. International Financial Management Vicentiu Covrig 8 Does the Cost of Capital Differ among Countries? There do appear to be differences in the capital structure and cost of capital across countries Companies from developed markets where banking sector plays a more important role than public markets have larger debt/equity ratios and lower cost of capital When markets are imperfect, international financing can lower the firm’s cost of capital.

9. International Financial Management Vicentiu Covrig 9 Cross-Border Listings of Stocks  Firms operating in segmented markets(e.g. small and illiquid capital markets; emerging markets) can raise new capital and lower their cost of capital by cross- listing their stock on large, liquid markets  Cross-Listing refers to a firm having its equity shares listed on one or more foreign exchanges. Cross-border listings of stocks have become quite popular among major corporations. The largest contingent of foreign stocks are listed on the London Stock Exchange and U.S. exchanges

10. International Financial Management Vicentiu Covrig 10 Cross-Border Listings of Stocks Cross-border listings of stocks benefit a company in the following ways. 1. The company can expand its potential investor base, which will lead to a higher stock price and lower cost of capital. 2. Cross-listing creates a secondary market for the company’s shares, which facilitates raising new capital in foreign markets. 3. Cross-listing can enhance the liquidity of the company’s stock. 4. Cross-listing enhances the visibility of the company’s name and its products in foreign marketplaces.

11. International Financial Management Vicentiu Covrig 11 Cross-Border Listings of Stocks Cross-border listings of stocks do carry costs. 1. It can be costly to meet the disclosure and listing requirements imposed by the foreign exchange and regulatory authorities. 2. Once a company’s stock is traded in overseas markets, there can be volatility spillover from these markets. 3. Once a company’s stock is made available to foreigners, they might acquire a controlling interest and challenge the domestic control of the company.

12. International Financial Management Vicentiu Covrig 12 The following sections in chapter 16 are not required for the exam: - Capital asset pricing under cross-listings - Asset Pricing under foreign ownership restrictions -The financial structure of the subsidiary

13. International Financial Management Vicentiu Covrig 13 Learning outcomes Know how to calculate a MNC’s costs of equity capital (using both domestic index and world index) and WACC (see the example on slides 6 and 7) Suppose that your firm is operating in a segmented capital market. What actions do you recommend to mitigate the negative effects? Does the cost of capital differ across countries? Explain the benefits for a firm that cross-lists. Explain the costs for a firm that cross-lists. Explain why a firm’s cost of capital may decrease when the firm’s stock is cross- listed abroad Recommended end-of-chapter questions: 1, 2 and 9