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CHAPTER 14. THE COST OF CAPITAL FOR FOREIGN INVESTMENTS. CHAPTER OVERVIEW:. I. THE COST OF EQUITY CAPITAL II. THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS III. THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS IV. DISCOUNT RATES

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chapter 14

CHAPTER 14

THE COST OF CAPITAL FOR FOREIGN INVESTMENTS

chapter overview
CHAPTER OVERVIEW:
  • I. THE COST OF EQUITY CAPITAL
  • II. THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
  • III. THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS
  • IV. DISCOUNT RATES
  • V. ESTABLISHING A WORLDWIDE CAPITAL STRUCTURE
i the cost of equity capital
I. THE COST OF EQUITY CAPITAL
  • A. Definition
  • 1. the minimum (required) rate of return
  • necessary to induce investors to buy
  • or hold the firm’s stock.
  • 2. used to value future equity cash flows
  • 3. determines common stock price
the cost of equity capital
THE COST OF EQUITY CAPITAL
  • B. Capital Asset Pricing Model
  • ri = rf + i ( rm - rf )
  • where ri = the equity required rate
  • rf = the risk free return rate
  • i= Cov(rm, ri)/ 2 rm where
the cost of equity capital5
THE COST OF EQUITY CAPITAL
  • Cov(rm, ri) is the covariance between asset and market returns and 2 rm , the variance of market returns.
ii the weighted average cost of capital for foreign projects
II. THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
  • II. THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
  • A. Weighted Average Cost of Capital (WACC = k0)
  • k0 = (1-L) ke + L id (1 - t)
  • where L = the parent’s debt ratio
  • id (1 - t) = the after-tax debt cost
  • ke = the equity cost of capital
the weighted average cost of capital for foreign projects
THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
  • k0 is used as the discount rate in the
  • calculation of Net Present Value.
  • 2. Two Caveats
  • a. Weights must be a proportion using
  • market, not book value.
  • b. Calculating WACC, weights must be
  • marginal reflecting future debt
  • structure.
the weighted average cost of capital for foreign projects8
THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
  • B. Costing Various Sources of Funds
  • 1. Components of a New Investment (I)
  • I = P + E f + D f
  • where I = require subsidiary financing
  • P = dollars by parent
  • E f = subsidiary’s retained earnings
  • D f = dollars from debt
the weighted average cost of capital for foreign projects9
THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
  • 2. First compute each component
  • a. Parent’s company funds (k0)
  • required rate equal to the marginal
  • cost of capital
  • b. Retained Earnings (ks)
  • a function of dividends, withholding taxes, tax deferral,
  • and transfer costs.
  • ks = ke (1-T)
the weighted average cost of capital for foreign projects10
THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
  • c. Local Currency Debt (rf)
  • after-tax dollar cost of borrowing
  • locally
the weighted average cost of capital for foreign projects11
THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS
  • C. Computing WACC(k1)
  • k1 = k0 - a(ke -ks) - b[ id(1-t) - if ]
iii the all equity cost of capital for foreign projects
III. THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS
  • III. THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS
  • A. WACC sometimes awkward
  • 1. To go from the parent to the project
  • 2. Solution: Use all equity discount rate
  • 3. To calculate:
  • k* = rf + *( rm - rf )
the all equity cost of capital for foreign projects
THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS
  • 4. *is the all-equity beta associated with
  • the unleveraged cash flows.
the all equity cost of capital for foreign projects14
THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS
  • 5. Unlevering beta obtained by
  • where B* = the firm’s stock price beta
  • D/E = the debt to equity ratio
  • t = the firm’s marginal tax
iv discount rates for foreign projects
IV. DISCOUNT RATES FOR FOREIGN PROJECTS
  • IV. DISCOUNT RATES FOR FOREIGN
  • PROJECTS
  • A. Systematic Risk
  • 1. Not diversifiable
  • 2. Foreign projects in non- synchronous economies should be
  • less correlated with domestic markets.
discount rates for foreign projects
DISCOUNT RATES FOR FOREIGN PROJECTS
  • 3. Paradox: LDCs have greater political
  • risk but offer higher probability of
  • diversification benefits.
discount rates for foreign projects17
DISCOUNT RATES FOR FOREIGN PROJECTS
  • B. Key Issues in Estimating Foreign Project Betas
  • -find firms publicly traded that share
  • similar risk characteristics
  • -use the average beta as a proxy
discount rates for foreign projects18
DISCOUNT RATES FOR FOREIGN PROJECTS
  • 1. Three Issues:
  • a. Should proxies be U.S. or local
  • companies?
  • b. Which is the relevant base portfolio to use?
  • c. Should the market risk premium be
  • based on U.S. or local market?
discount rates for foreign projects19
DISCOUNT RATES FOR FOREIGN PROJECTS
  • 2. Proxy Companies
  • a. Most desirable to use local firms
  • b. Alternative:
  • find a proxy industry in the local market
discount rates for foreign projects20
DISCOUNT RATES FOR FOREIGN PROJECTS
  • 3. Relevant Base (Market) Portfolio
  • a. If capital markets are globally
  • integrated, choose world mkt.
  • b. If not, domestic portfolio is best
discount rates for foreign projects21
DISCOUNT RATES FOR FOREIGN PROJECTS
  • 4. Relevant Market Risk Premium
  • a. Use the U.S. portfolio
  • b. Foreign project: should have
  • no higher than domestic risk
  • and cost of capital.
v establishing aworld wide capital structure
V. ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE
  • V. ESTABLISHING A WORLDWIDE
  • CAPITAL STRUCTURE
  • A. MNC Advantage:
  • uses more debt due to diversification
establishing aworld wide capital structure
ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE
  • B. What is proper capital structure?
  • 1. Borrowing in local currency helps
  • to reduce exchange rate risk
  • 2. Allow subsidiary to exceed parent
  • capitalization norm if local mkt.
  • has lower costs.