1 Global Cost of Capital and Financial Structure International Financial Management Dr. A. DeMaskey

2 Learning Objectives What is a firm’s cost of capital? How is the cost of capital for foreign investments determined? What key issues are involved in applying the CAPM to estimating the cost of equity capital for foreign projects? How is the effective dollar cost of debt determined? What should be the MNC’s worldwide capital structure?

3 Weighted Average Cost of Capital WACC= w d k d (1 - T) + w e k e where: w i = proportion of source of capital used in the capital structure; k i = marginal cost of source of capital; T = corporate tax rate.

4 The Cost of Equity Capital The CAPM Approach k s = k RF + (k M - k RF )b i where: (k M – k RF )b i = risk premium b i = systematic risk k M – k RF = market risk premium

5 Beta Coefficient Beta is the measure of systematic risk for asset i, which is computed as: Where: ρ im = correlation between asset i and the market σ i = standard deviation of returns on asset i σ m = standard deviation of returns on the market portfolio

6 The Cost of Debt Capital Cost of debt requires:  Interest rate forecast for next few years  Proportion of various classes of debt the firm expects to use  Corporate income tax rate Effective cost of debt: k d ’ = k d (1 – T)

7 The Weighted Average Cost of Capital for Foreign Projects If project risk and financial structure for a foreign project varies from the corporate norm, the costs and weights of the different cost components must be adjusted to reflect their actual values. The project’s WACC will equal: WACC’ = w d ’k d ’(1 - T) + w e ’k e ’

8 Key Issues in Estimating Foreign Project Discount Rates Should the corporate proxies be U.S. or local companies? Is the relevant base portfolio against which the proxy beta are estimated the U.S. market portfolio, the local portfolio, or the world market portfolio? Should the market risk premium be based on the U.S. market or the local market? How should country risk be incorporated in the cost of capital estimates?

9 Proxy Companies Local Companies Proxy Industries Adjusting U.S. Industry Beta

10 The Relevant Base Portfolio Home Market Portfolio r i = r f + b ius (r us – r f ) Global Capital Asset Model r i = r f + b ig (r g – r f ) where:

11 The Relevant Market Risk Premium U.S. Market Risk Premium  Mostly U.S. investors  Foreign betas should be estimated relative to the U.S. market  Statistical validity of U.S. capital market data

12 Estimating the Equity Cost of Capital for the Foreign Subsidiary Find proxy portfolio in country in which subsidiary operates Calculate beta relative to U.S. market Multiply beta by the risk premium for U.S. market Add estimated equity risk premium for foreign subsidiary to U.S. riskfree rate

13 The Cost of Debt Capital Dollar cost of LC loan:  r L (1 + c) + c After-tax dollar cost of LC loan:  r L (1 + c)(1 – t a ) + c Multiyear LC loan  Without taxes  With taxes

14 Establishing a Worldwide Capital Structure Consolidated worldwide capital structure Optimal global financing plan  Cost and availability of other sources Worldwide debt ratio  Default risk  Target capital structure

15 Subsidiary Capital Structure: Funding Sources Parent raises capital in home country and invests these funds as equity  Subsidiary debt ratio is zero Parent invests one dollar of share capital in subsidiary and requires all to finance operations on its own  Subsidiary debt ratio is 100% Parent borrows funds and relends monies as an intercorporate loan to subsidiary  Subsidiary debt ratio is 100%

16 Subsidiary Financial Structure Subsidiary financial structure is not independent.  Debt/equity ratio of subsidiary is irrelevant  Focus is on worldwide capital structure  Vary subsidiary capital structure to take advantage of local financing opportunities

17 Foreign Subsidiary Capital Structure Conform to that of the parent company Reflect the capitalization norms in each foreign country Vary to take advantage of opportunities to minimize the parent firm’s cost of capital

18 Cost of Capital for MNCs versus Domestic Firms Is the WACC or an MNC higher or lower than for its domestic counterpart? The answer is a function of:  The marginal cost of capital  The after-tax cost of debt  The optimal debt ratio  The relative cost of equity An MNC should have a lower cost of capital because it has access to a global cost and availability of capital This availability and cost allows the MNC more optimality in capital projects and budgets compared to its domestic counterpart