International Cost of Capital
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ISBN9780 International Finance
Part 1: International Cost of Capital
1
Reading
• Shapiro, A. (2010), Multinational Financial Management,
Ninth Edition, Wiley, ISBN 978-0-470-45035-2
• Tenth Edition is also available now
• International Cost of Capital: Ch 14
• International Portfolio Investment: Ch 15.
N.B. There are many copies in the library
2
Introduction
• Part 1:
• Revisit the CAPM very quickly
• Look at how we can use the CAPM to calculate the cost of equity
capital for MNC subsidiaries.
• See if the cost of a project in a foreign country should have a
lower cost of capital than a similar project domestically.
• Address some of the issues in calculating this cost of equity
capital via the CAPM.
3
Capital budgeting
• Investment selection
• Capital budgeting process of selecting capital investments to maximise MNC
shareholder value
• NPV
• A project’s NPV determines the project’s impact on shareholder value.
• You will recall the following:
where
• Only accept +ive NPV projects.
4
∑
=
+
+=
n
t
NCFt = net cash flow in time t
I0 = initial investment
k = cost of capital (i.e. WACC)
n= investment horizon
t
t
k
NCFNPV -I
1
0 )1(
Cost of capital
• WACC (ignoring taxes)
• α = Firm's debt structure (debt to total assets)
• Ke = Cost of equity capital
Required return on the firm's stock given the particular debt ratio
selected
• Kd = Cost of debt
• The minimum rate risk adjusted return required by shareholders of the firm
to undertake a given investment.
• i.e. minimum rate of return to induce investors to hold the firm’s stock
• Or alternatively, think of the cost of capital as the weighted average return
required for each of the firms activities.
• Therefore the company represents the sum of those projects, and the sum of
the value of those projects should equate to the value of the company.
5
de kkk αα +−= )1(
CAPM and Equity Cost of Capital
CAPM RECAP
• CAPM tells us there exists an equilibrium relationship between an
assets required return and its associated risk.
• That intelligent risk-averse investors will diversify away risk, the
remainder being the risk that attracts a risk premium.
• Diversification: essentially spreading your investments broadly
across industry sectors, countries, and asset types to reduce risk.
• How is risk reduced? By trying to get a collection of assets into your portfolio
that move together (co-vary) as little as possible.
6
CAPM and Equity Cost of Capital
• Though diversification we are able to get rid of diversifiable risk
(sometimes called non-systematic or idiosyncratic risk)
• What is left is nondiversifiable risk (sometimes called systematic or
market risk)
• It is this risk that attracts the premium.
• Indeed, why should the market pay you for holding diversifiable
risk?
7
CAPM and Equity Cost of Capital
The CAPM:
where
ri = equilibrium expected return for asset i
rf = rate of return on the risk free asset
rm = expected return on the market portfolio consisting all risky
assets.
βi = how the expected return of a stock is correlated to
the return of the market portfolio
8
)( fmifi rrrr −+= β
CAPM and Equity Cost of Capital
• More on beta:
where
cov(ri, rm) = covariance between ri and rm
ρim = correlation between ri and rm
σm = standard deviation of market
Positive β : Moves with market
Negative β : Moves against the market
Zero β : not correlated with the market
9
m
iim
m
mi
i
rr
σ
σρ
σ
β == 2 ),cov(
Beta and MNC
• Importance of Beta
• Consider a multinational firm
• The effect of a foreign project’s risk on its cost of capital depends
only on that project’s systematic risk.
• i.e. the proportion of return variability that cannot be eliminated
through diversification.
• The standard view is that much of the risk faced by the MNC is
diversifiable.
• But surely investing overseas can be quite risky?
10
Beta and MNC
• Yes and no. Where it is risky, low correlation between project
and market returns can sometimes offset the effects of higher
project risk.
• Consider now market risk
• Assume we define the market portfolio proxy to be the domestic
index
• The constituents of market portfolio will, to an extent, be
correlated due to the fact they are in the same economy.
• Consider then two similar projects, one domestic and one
foreign.
11
Beta and MNC
• Given that the foreign project is unrelated to the domestic
economy (e.g. business cycle etc), it will maybe be less correlated
with the market portfolio, thus having a lower market risk.
• Consider now an LDC – they can often provide even more
diversification benefits than a project in a foreign DC, despite the
fact that they are be seen as risky. Why? Such economies are
going to be far less influenced and in tune with DC’s.