Global Cost of Capital Chapter 11 June 22, 20161Chapter 11 - wacc

Weighted average cost of capital (WACC) k e - cost of equity k d - cost of debt T c - corporate tax rate E - market value of equity D - market value of debt V - total market value of the firm’s securities June 22, 20162Chapter 11 - wacc

June 22, 2016Chapter 11 - wacc3 WACC effects  Capital budgeting Pro forma income statements are required for each period The NPV of the NCFs is inversely related to the value of the wacc

WACC effects k wacc  If you can lower your wacc, more projects become profitable. capital budget MRR k June 22, 20164Chapter 11 - wacc

Leverage effects kdkd  leverage effects determine an optimal level of leverage keke k wacc leverage June 22, 20165Chapter 11 - wacc

Market efficiency  perfect information standardized accounting practices standardized reporting practices  no transactions costs  no regulatory costs governments do not try to restrict capital markets  no monopolistic influences in the market place June 22, 20166Chapter 11 - wacc

Cost of equity – FDI (efficient capital markets)  dividend capitalization model  capital asset pricing model June 22, 20167Chapter 11 - wacc

June 22, 2016Chapter 11 - wacc8  Mature capital markets have bond rating agencies AAA, AA, A, BBB, BB, BB, C, D  The ratings determine the cost of debt to the firm The type of debt instrument  Mortgage bond, coupon bond, discount bond Cost of Debt – FDI (efficient capital markets)

Inefficient markets  imperfect information (information barriers)  high transactions costs exchange rate exposure  regulatory costs capital restrictions exchange restrictions political risk  no competition to exchange June 22, 20169Chapter 11 - wacc

Cost of equity – FDI (inefficient capital markets)  If there are no reliable measures of risk in an economy we must make an informed guess by applying a Risk Premium to the domestic return on equity June 22, 2016Chapter 11 - wacc10

Cost of debt - FDI (inefficient capital markets)  Normal debt markets immature  Governments may offer incentives Lower interest rates, tax relief,  Supra-national agencies may offer incentives to invest UN, IMF, etc. June 22, 2016Chapter 11 - wacc11

Relative market efficiency 100%0% Russian N. American W. European, Asian S. American, E. European June 22, Chapter 11 - wacc

Segment capital markets  Capital markets are internal to the economy Borrowers and lenders are confined to the geographic confines of the country European union prior to the euro  Finnish firms could finance only from Finnish sources  Argentine firms could finance only from Argentinian sources June 22, 2016Chapter 11 - wacc13

Integrated (consolidated) capital markets  Euro zone With currency unification, capital markets within the euro zone are integrating  Lenders and borrowers have much better opportunities  The market becomes thicker so the prices of borrowing are more efficient  Canada/US is an integrating market June 22, Chapter 11 - wacc