International Finance FN 6063/5053

1. International Finance FN 6063/5053 COST OF CAPITAL for international Investments Lecture 10

2. Cost of Capital For Foreign Investment • The C.O.C is an extremely important number, since it gives us a “naturalhurdlerate” in making project evaluations decisions. • In international finance, the central issue is what is the “appropriate C.O.C.” to use in evaluating foreign projects. • Many of the issues that have to be considered in arriving at a COC for domestic use also arise for foreign projects, and then some additional considerations. • Since a company grows in value by taking on new projects that add to its value, the COC number has to be carefully computed - failing which there could be “destruction” of value. • The appropriate discount factor is the WACC  which is a weighted average of the components of a company’s capital structure. • The typical components of WACC would be equity, debt and preferred stocks.

3. Components Costs: (A) Equity • Cost of Equity • 1. Historical estimate : based on the past rates of return. • . Risk premium approach. • . DDM (Dividend Discount Model) • 4. CAPM (Capital Asset Pricing Model) 4 Commonly Used Techniques

4. (1) Using Historical Estimates • Under this technique, cost of equity capital Keis arrived at by simply estimating the historical rate of returns of the company’s stock over several years and taking the average. • This total returns would typically be both capital gains returns anddividendyields (% capital gains + % dividend yields averaged). • A variant is to use average Price-Earnings (P/E) ratios → that is the reciprocal of the P/E multiple.

5. (2) Risk Premiums Approach • An arbitrary approach → making use of the company’s cost of debt historically and adding a premium 4-6% to arrive at Ke • Often, take the YTM of Company’s bonds and add a risk-premium. Logic is based on the fact that Ke is always > Kd • Kd = cost of debt

6. (3a) Dividend Growth Model (DGM) • The DGM arrives at the value of a company’s shares (Po) after taking into account the rate at which the company’s dividend grows over time (g) and the cost of equity capital (Ke). • The DGM assumes that the company’s dividend would grow at a constant rate g per annum. • Suppose a company’s expected dividend for the upcoming year (d1) is set equal to MYR 1, and g = 3%, and its Ke= 9.2%, the value of the company’s stock would be MYR 16.13 [1/0.092-0.03 = 16.13] • Note that smaller Ketranslates to higher stock value.

7. (3b) Dividend Discount Model - DDM Therefore; the implied

8. (3) DGM-DDM Example Return to the previous example, where: • Po = 16.13 • d1 = RM 1 • g = 3% • Ke = (1/16.13) + 0.03 = 0.092 or 9.2%

9. (4) Capital Asset Pricing Model (CAPM) • The CAPM makes a distinction between diversifiable risk and non-diversifiable risk. • Non-diversifiable risk is referred to as “systematic risk”. • The only risk that will be rewarded with risk premium is the systematic risk, as the rest can be diversified away. • The equilibrium expected return for asset i (=ri) will depend on the return on a risk-free asset (rf), and expected return on the market portfolio consisting of all risky assets (rm), and Beta-which in turn depends on thecorrelationbetween return on security I (ri)and that on market portfolio (rm), and the standard deviation of returns on asset i relative to that of returns on the market portfolio [Shapiro: Chapter 14, p. 519]. Beta measures systematic risk.

10. Systematic Risk (Beta) • As mentioned, Beta depends on the correlation between the return on security i (ri )and that on the market portfolio (rm)and the standarddeviation of returns. • Investment risks associated with Hong Kong and Singapore are roughly twice that of the US market (as shown by standard deviation numbers), but both markets havebetassubstantially lower than the US market beta (Shapiro: Chapter 14, Table on p. 519) • The reason for lower Beta despite higher risks (Hong Kong & Singapore) lies in the fact much of the risk in the two markets is unsystematic and can be eliminated by diversification

11. (4) Capital Asset Pricing Model (CAPM) • Use CAPM • Where is the measure of systematic risk. To estimate • When computing Ke for new equity that is for newly issued stock, a small adjustment would have to be made for floatation costs. • Since floatation costs are small, they are often ignored. However, to adjust, simply add the % floatation cost to the computed Ke using CAPM or DDM. Stock Return % Market Return

12. Component Costs: (B) Cost of Debt Bank loans → Bonds → the YTM, using current prices. In both cases, since interest expense is tax-deductible →

13. Component Costs: (C) Cost of Preferred Stock • Simply, since, dividend paid on Preferred Stock is not tax deductible, no tax adjustment. Current price of preferred stock.

14. The Weighted Average Cost of Capital (WACC) • Having determined the cost of individual capital components, we’re ready to compute the WACC to be used as discount factor [Domestic Investment] • * Note: always use market values in computing weights. • There are 2 situations under which WACC will have to be recomputed. • If the weights have changed – e.g. suppose new debt, or new equity is used causing a ∆ in weights. • If the risk profile has changed: the risk profile of the new project, for which the K is being computed, is different from the company’s current risk profile.

15. Costing of Funds in International Investing • Exactly as we would cost the source of funds in determining WACC for domestic investments, we would need to cost the cost of funds in international investing, too. • Typically, there are 3 categories of fund sources in international investing; • Funds from parent i.e. new equity (Wp) • Internal funds of the foreign subsidiary, i.e. reinvestment of retained earnings (Wres) • Debt raised in the country of the foreign subsidiary, i.e. LC-denominateddebt (Wndf)

16. Costing of Funds in International Investing • Funds from parent  cost would simply be the parent’s WACC  adjusted if necessary for  in risk or  in weights. • Internal funds of foreign subsidiary  come from its retainedearnings • As the subsidiary’s equity belongs to the parent, the relevant cost is parent’s – adjusted for any withholding taxes on repatriated profits: • Foreign Debt Debt denominated in local currency : • Here, the cost would be the cost of the foreign loan (interest rate) but adjusted for exchange gain/loss.

17. Cost of Capital for Foreign Investment • EXAMPLE  modified from text. Suppose a new foreign investment requires initial investment of RM 100 mil. • RM 20 mil of these come from the parent company in Malaysia. • RM 25 mil from the retained earnings (RE) of its foreign subsidiary. • And RM 55 mil. from debt financing in the country of foreign subsidiary. Parent’s Equity: • Parent’s = 14%; After-tax cost of debt = 6%; Parent’s current debt ratio is 30%. • The new foreign investment, however, has higher risk and parent requires Ke of 16% for new equity (reflecting the higher risk level).

18. Cost of Capital for Foreign Investment Retained Earnings of the Foreign Subsidiary: • Withholding tax of 8% on repatriated profits (the cost of equity is equivalent to parent’s of 16%). Cost of New Foreign Debt: • Interest (Kndf) is 20%; foreign corp. tax = 40%; foreign subsidiary’s LC is expected to devalue by 7% over the future. • So, the correct “K” to be used by parent in discounting the new project would have to be computed using the above information.

19. Cost of Capital for Foreign Investment Component Costs: • Parent COC = • Cost of Subs RE = • Cost of New foreign Debt foreign Debt = adj. cost of foreign debt with expected devaluation. Now that we know the component costs, let us impute their weights for the RM100 million initial investment.

20. Cost of Capital for Foreign Investment • Note: the logic in getting item 3 cost of new foreign debt is that the foreign currency must have 7% higher inflation for example, and therefore the currency  7%, thus, after adjusting for this 7% differential, we get a “real” interest rate of 12.15%. Alternatively, we could have it as (20 – 7) = 13%.   The logic

21. Cost of Capital for Foreign Investment • In terms of 1 long equation. Note: Your text goes into a lengthy discussion of why CAPM  is a relevant model for estimating . It talks especially about why beta that measures only systematic risk is relevant. • The argument is basically that even isolated LDC’s are tied to the world economy, such that political risk etc. represent unsystematic risk that can be diversified away  and is therefore irrelevant risk. • Read the section on your own.

22. Cost of Capital: Japan vs US Comparing COC between Japan & US: • Conventional wisdom says COC in Japan is much lower than the US’, thereby giving Japanese firms a major competitive advantage. • The reasons often cited for Japan’s lower COC: • (a) lower interest rates in Japan, given much higher savings rate (note that in its Balance of Payments, Japan has huge Capital a/c deficit  exports capital) and hence lower • (b) is also lower since P/E multiple are much higher. • Additionally, Japanese COs also appeartohave much higher leverage ratiosthan US Cos. This means that they use the “cheaper source” of capital  and therefore have lower overall COC.

23. Cost of Capital: Japan vs US • However, when adjustments are made for : • Diff. inflation and tax rates, the real after-tax interest is not really diff. • When P/E ratios are adjusted for : • higher expected growth rates, lower dividend payouts, and “under-reported” earnings; holdings of less the 20% of stock by a company is not allowed by Japanese law to be consolidated into the holding cost, profit, etc. • Therefore, Price-Earnings (P/E )ratios are not all that different after all. • In Japan, as market values of assets rather than book values are used for assets, and the more restrictive banking system requires companies to hold more cash, appropriate adjustments are called for. • Thus, it turns out that Japanese COs do not really have higher financial leverage after all.

24. Globalization of COC • The argument that Japanese COs, have much lower COC, giving them ahugeadvantageis thus not really true. They do have an advantage but much narrower than it might appear: 1 – 3% lower COC. Globalization at work! • Illustration of Novo Industri • Novo Industri – a Danish pharmaceutical Co. “internationalized” its high domestic COC by going into Europe with Eurobonds and listing its shares on the London Stock Exchange and on the US over-the-counter market (Nasdaq). • The big reason for high COC in Denmark is that investors, faced with very high tax rates, require high pre-tax returns. In addition, highly correlated Danish stock price movements meant that Danish investors bore a great deal of systematic risk, raising their required returns (Danish investors were prohibited from investing in foreign stocks).

25. Concluding Observations • KEY FACTORS DETERMINING THE APPROPRIATE MIX OF DEBT AND EQUITY FINANCING OF FOREIGN INVESTMENT PROJECTS: • Cost of equity for the parent company • Cost of debt for the parent (after tax) • Parent’s debt-equity ratio • Cost of foreign debt (taking into account inflation rate, interest rate and exchange rate changes) • Taxes in the country of foreign subsidiary (corporate & withholding) • Systematic risk and risk premium • Extent of unsystematic risks that can be eliminated through diversification

26. Concluding Observations (cont’d) HIGHLIGHTS • Systematic risks are non-diversifiable. • Unsystematic risks can be eliminated by diversification • Rate of return on risk-free assets (e.g. US Treasury Bills) is low • Market risk premium = rate of return on the market portfolio minus rate of return on risk-free assets • The only risk that will be rewarded with a risk premium is systematic risk • LDCs offer more diversification benefits than DCs for foreign investment • LDCs’ ratio of systematic to total risk relatively low • Corporate international diversification is beneficial to shareholders • Shareholders willing to accept lower rate of return on MNC shares than on shares of uni-national firms • Cost of equity capital (Ke) > cost of borrowed capital (Kd)

27. Concluding Observations (cont’d) EMPERICAL EVIDENCE • Foreign investment generally is more risky relative to domestic investment, but much of the risks associated with foreign investment consists of unsystematic variety that can be eliminated through diversification. • LDCs’ weak correlation with the US market more than offsets their large standard deviation of returns, thereby yielding a lowerbeta(systematic risk) from the US perspective.

28. 2011 Examination Question (6) • What factors do matter in determining the appropriate mix of equity and debt financing for parent and affiliates? (3 marks) • Suppose a new foreign investment project in Vietnam requires MYR100 m of which (i) MYR30m comes from parent company in Malaysia, (ii) MYR20m from retained earnings of foreign subsidiary in Vietnam, (iii) MYR50m in the form of debt financing in the host country. Assume the following: (i) parent’s cost of equity (Kep) is 16%; (ii) parent’s after-tax cost of debt is 6%; (iii) parent’s debt-equity ratio is 30% (iv) foreign subsidiary in Vietnam is subject to 8% withholding tax on repatriated profits and 40% corporate tax (v) local currency of foreign subsidiary (i.e. dong) is expected to devalue in the foreseeable future by 7%; and (vi) local interest rate (in Vietnam)is 20% Based on the above information, compute the correct “K” (Weighted Average Cost of Capital) to be used by parent in discounting the new project. (8 marks)

29. YOU MAY GIVE IN, BUT NEVER GIVE UP! END OF LECTURE 10