1. Cost of Capital for Overseas Investments Dr. Himanshu Joshi

2. Cost of Capital for Foreign Investments Because of different degrees of risk of the various operations, managers of multinational firms often wants to apply different cost of capital for subsidiaries or divisions in different countries. WACC approach does not work very well for finding the cost of capital for overseas divisions, since a firm’s stake in these divisions does not generally have its own separate financing. (no local financing)

3. Cost of Capital for Foreign Investments We need to develop a different approach for the cost of capital for an overseas division. We also need to develop a different approach to deal the division in an emerging market where there are additional risks to consider. A multinational company sometimes wants to measure an overseas division’s cost of capital from US dollar perspective, and some time from the local foreign currency perspective.

4. Cost of Capital for Foreign Investments For global performance evaluation and overall strategic planning, a US headquarters may use the cost of capital estimate from the US dollar perspective. For decentralize decision making, an overseas subsidiary may want a cost of capital expressed in terms of the local currency that is consistent with the division’s cost of capital in terms of US dollar. We will learn how to make these conversion.

5. Operating Risk Approach Multinational corporation can be viewed as a portfolio of subsidiaries. The overall intrinsic value of the multinational is viewed to be the sum of the intrinsic values the subsidiaries would have if they were independent operations. Based on this value-additivity principle, each subsidiary’s risk contributes to the multinational’s overall “portfolio” risk. The cost of capital of an overseas subsidiary is the rate of return that would be required in global financial market as a compensation for risk if the subsidiary were independently owned and traded.

6. Operating Risk Approach If a division tends to contribute an above-average amount to a multinational’s overall “portfolio” risk, its cost of capital should be higher than the multinational’s overall cost of capital. What If the company’s overall cost of capital is used in this case as division’s cost of capital? What is the company’s overall cost of capital is higher than its foreign division’s cost of capital, but we are using the overall cost of MNC?

7. Operating Risk Approach And if division’s risk tends to be lower the multinational’s overall risk, the division’s cost of capital should be lower than over-all cost of capital. If not?

8. Operating Risk Approach The Operating Risk framework suggests that we use a model of risk and return based on the company’s operating risk. We can think of a company’s operating risk as the risk the asset’s owners would have if the company were entirely equity financed. In the context of global CAPM, a company’s operating risk is its (global) operating beta, which is basically the beta of the company’s intrinsic value (all equity financed company). You can plug the operating beta into the global CAPM to arrive at the company’s cost of capital as an alternative to WACC.

9. Operating Risk Approach Since we don’t know the financing components weights and costs of subsidiary, we’ll use operating risk approach.

10. Operating Risk Approach We have noted that an overseas division has an operating risk that may differ from the multinational’s overall operating risk. Reasons may be: 1.Divisions and multinational are likely to define their basic relationship with the global economy in different ways. (sales volume and operating cost of Maruti –Suzuki have a different correlation with the global market than the parent Suzuki.) Thus operating beta of Maruti Suziki will be different from operating Beta of Suzuki Japan.

11. Operating Risk Approach 2. Another reason is the difference in FX operating exposures. The FX operating exposures is lower for foreign subsidiary that produce locally and higher for those that operate more as assembly or distribution business. 3. Overseas division’s operating risk may differ form that of the firm as a whole if the division is in an emerging market country. (less integrated with the global markets, expropriation risk, risk of policy change)

12. Operating Risk Approach How to estimate the operating beta and cost of capital for a division in a developed country. Plug the estimated operating beta into the global CAPM to estimate the cost of capital for the division. Adjustments that may be appropriate if the division is in an emerging market. Conversion of USD cost of capital into equivalent foreign currency.

13. Approach #1 Accounting Beta Method.. An accounting beta is estimated by regressing a time series of Return on Assets (ROA) observations against the corresponding returns of the global market index. We first find the division’s accounting beta ratio. Which is the ratio of division’s operating beta to the multinational’s overall accounting beta. We then assume that the accounting beta ratio is equal to operating beta ratio. By knowing the accounting beta ratio and the overall firm’s operating beta, we can estimate the division’s operating beta.

14. Accounting Beta Method Suppose the US Global Corporation is the parent of divisions in the United States, Europe, and Japan. Assume that the accounting beta of the US division is.40, the accounting beta of the European division is 0.50, and of the Japanese division is 0.60, and the accounting beta of the global corporation as a whole is 0.50. If US global corporation’s overall operating beta is 0.90.

15. Accounting Beta Method Accounting beta ratios: US Division = 0.4/0.5 =0.8 Europe Division = 0.5/0.5 =1 Japanese Division = 0.6/0.5 =1.2 Operating Betas: US Division = 0.8*0.9 = 0.72 Europe Division =1*0.9 = 0.9 Japanese Division = 1.2*0.9 = 1.08.

16. Question.. In US dollars, the accounting beta of Special Chemical Company (SCC) as a whole is 0.45 and for its Australian subsidiary is 0.90. assume that the operating beta for SCC is 0.80. What is the estimated operating beta for the Australian division according to the accounting beta method? Assume US dollar risk free rate is 5% and a global risk premium of 4%. What is the Australian division’s cost of capital in US dollars according to the global CAPM?

17. Accounting Beta Logic? The logic of the accounting beta method is that managers have the information to estimate the accounting betas of a division and the overall firm. That is, they know something about a division’s accounting beta from the inside, while the market (in the form of returns) does not reflect this information.

18. Question.. Why we can not directly use the division’s accounting beta in Global CAPM? Accounting betas are different from return betas, because market sentiment and other factors enter into returns in the market. Source: J. Campbell and J. Mei, “Where do betas come from? Asset Price Dynamics and the Sources of Systematic Risk,” Review of Financial Studies, Vol. 6, 1993, 567-592.

19. Approach #2 Country Beta Method An alternative to the accounting beta method is the country beta method. This method assumes that a division’s operating beta ratio is equal to the ratio of the division’s country beta to the overall world beta. Ratio = Division’s country beta /world beta.

20. Division’s Country Beta A country beta in US dollar, β c $, may be estimated by regressing the returns of a country’s equity index against the return of the global market index, expressing both index returns in US dollars. Country beta method boils down to estimate a division’s operating beta by multiplying the company’s overall operating beta time the country beta for the country that the division is in. Division’s Operating Beta = Company’s Overall Operating Beta* Country Beta (Division)

21. Country Beta Method.. A US multinational Unilever with an overall operating beta of 0.50 has a subsidiary in India, HUL. If India has country beta of 1.67. What is the operating beta of HUL?

22. Q? Country Beta Method.. SCC is a US MNC with an estimated overall operating beta relative to the global market index of 1.45. assume that the country beta of the Australian equity market to global index is 0.862. What is operating beta of SCC’s Australian Division? Can it’s Australian division accept a project in local market giving return of 11.5%. R $ = 6%, r A$ = 8%, Global Risk Premium = 4%.

23. Emerging Market Investments For investments in emerging markets, many companies add a premium for political risk to the usual premium for the global beta. Political risk is catchall term used to describe the additional risks posed by emerging market investments in terms of liquidity, civil disruptions, corruption, political interventions, expropriation, imposition on control of funds….

24. Emerging Market Investments We may think of the political risk premium for country C, denoted by PR c $, as a premium above the global CAPM risk premium that global investors require for the political risk of investing in the country’s equity index portfolio. Many managers and analysts estimate a country’s political risk premium by the country’s sovereign risk premium. The spread between the yield on US dollar denominated sovereign bond issued by the country’s government (denoted by r sC $ ) and the yield on US treasury bond. Or yield spread between euro-denominated sovereign bonds issued by the country’s government and euro- denominated bonds issued by the Eurozone Authority.

25. Emerging Market Investments If the emerging market has no sovereign bonds denominated in US dollars or euros, then political risk is often measured as a function of country’s risk rating. Euro money Magazine, Institutional Investors Magazine, S&P. International country risk guide (ICRG): http://www.icrgonline.com/. (paid) http://www.icrgonline.com/ Prof. Campbell Harvey: http://www.duke.edu/~charvey/applets/Country Risk/test.html. (java tool to graph country risk) http://www.duke.edu/~charvey/applets/Country Risk/test.html

26. Emerging Market Investments K c $ = r f $ + β c $ [RP G $ ] + PR c $ Assume that the country’s global beta is 0.80 and its political risk premium is 5%. If the long term risk free rate in US dollar is 3.5% and the global risk premium is 4%, the required rate of return on the country index (in US dollars): 0.035+0.80*(0.04) + 0.05 =0.117 or 11.7%. The country risk premium would be 11.7% - 3.5% = 8.2%.

27. Emerging Market Investments Individual emerging market investments, subsidiaries, and divisions, pose different degrees of political risks to global inventors. We denote an emerging market investment’s sensitivity to the country’s political risk, that is political risk exposure as φ i $. Now cost of capital for an individual emerging market asset (in USD): K c $ = r f $ + β c $ [RP G $ ] + φ i $ [PR c $ ]

28. Q? Emerging Market Investment Assume that a US multinational wants to estimate the cost of capital in US dollars for its subsidiary in India. R Rs $ = 9.5%, R $ $ = 3.5%. Assume that India’s political risk premium is equal to its sovereign risk premium. Assume that the subsidiary is having beta of 1.2 with respect to the local industry. Assume that the subsidiary’s global operating beta is 1.25, global risk premium is 4%. K c $ = r f $ + β c $ [RP G $ ] + φ i $ [PR c $ ]

29. Damodaran Model for calculating political risk exposure.. Φ i $ Damodaran (2003) estimated Φ i $ for two Brazilian firms: Embraer, an aerospace Co. and Embratel, the large telecom company. Method#1. Ratio of firm’s local revenues to the local revenues of the average of the country. The more revenues comes from outside the country lower the political risk exposure. Embraer derives only 3% of its revenue locally, while Embratel derives 95% of its revenue locally. Average Brazilian firm generates 77% of its revenue locally.

30. Damodaran Model for calculating political risk exposure.. Φ i $ Method#2: Estimate Φ i $ as the coefficient of a time series of the firm’s equity returns (converted to US dollars) against the returns on a Brazilian sovereign bond (converted to USD). For Embraer 0.27 For Embratel 2.00

31. Question.. SCC is a US based MNC wanting to estimate the cost of capital in US dollars of its division in Chile. The division is an industry that has above average political risk. 80% of the division’s revenues are earned from domestic market, while an average firm earn only 60% of the revenue from the domestic market. the subsidiary’s operating beta is 0.75, and the long term risk free rate in US dollars is 3%, and the global risk premium is 4%. Assume that yield on long-term US dollar-denominated Chilean sovereign bonds is 8%, and that Chile’s political risk premium is equal to its sovereign risk premium. What is the Chilean division’s estimated cost of capital in US dollars?

32. Cost of Capital in Foreign Currency.. Managers often want to express a particular asset’s cost of capital in an overseas currency, given that the cost of capital is known in US dollars. An MNC may have an estimated US dollar cost of capital for a subsidiary that is based upon the subsidiary operating risk. It will want to supply the subsidiary’s managers with a consistent cost of capital in their own currency, so that they can make local investment decisions.

33. Cost of Capital in Foreign Currency.. Consider the Euro zone subsidiary AEM, with an estimated operating beta in US dollars of 1.25. assume a risk free rate in US dollar of 5%, and a global risk premium of 4%. Cost of Capital for AEM in USD terms using global CAPM will be: 5% + 1.25*4% = 10%. If want to value AEM in dollar terms we should cost of capital as 10%.

34. Cost of Capital in Foreign Currency.. We can also think AEM’s future cash flow stream from the point of view of Euros (or any other currency). The question is what discount rate should be used to find the present value of the cash flow stream measured in Euros. In other words, what is AEM cost of capital in Euros, consistent with its 10% cost of capital in US dollar?

35. Cost of Capital in Foreign Currency.. Conversion Approach: k i € = k i $ - E(x *$/€ ) + (1-Ę i€ $ ) σ € 2 k i € = k i $ - E(x *$/€ ) + (1-Ę i€ $ ) σ € 2 k i € = cost of capital in euros. k i $ = cost of capital in $. E(x *$/€ ) = equilibrium expected % change in the FX value of euro, relative to the USD. (1-Ę i€ $ ) = Ę i$ € σ € 2 = volatility of the euro.

36. Cost of Capital in Foreign Currency.. k i €, k i $, In words, equation says that to get asset i’s cost of capital in euros, k i €, we start with asset’s US dollar cost of capital k i $, E(x *$/€ ). then we adjust for the equilibrium expected percentage change in the FX value of the euro, relative to the US dollar E(x *$/€ ). This is the expected rate of FX change that is consistent with UIRP. x $/€. Ę i$ € σ € 2 or (1-Ę i€ $ ) σ € 2. Next we adjust for the statistical interaction between the asset’s returns in Euros and x $/€. Which can be expressed as Ę i$ € σ € 2 or (1-Ę i€ $ ) σ € 2. it is the covariance between asset’s return in Euros and FX value of euro w.r.t $

37. Cost of Capital in Foreign Currency. AEM.. Assume that long term risk free rate in US dollar is 5% and the long term risk free rate in Euros is 3%. Assume that FX global beta (β $ € ) of the euro is 0.125 and the global risk premium (in USD) is 4%. Use UIRP to get E(x *$/€ ) = r $ - r sf + β $ € (RP G $ ). Also assume that AEM’s exposure to the euro is 0.75. also assume that volatility of the euro is 10%.

38. Question.. Suppose the Japanese division of a US multinational has an FX operating exposure of 1.60 to the yen and a cost of capital in US dollar is 9%. The US dollar risk-free rate is 5% and yen risk free rate is 2%. The volatility of the yen is 0.16. what is the overseas division’s estimated cost of capital expressed in yen? To estimate the equilibrium expected rate of change in the FX value of yen, assume that the linear approximation of UIRP condition holds.

39. Pure Play Proxy Method.. An Alternative to Accounting Beta Method.. In proxy approach, operating beta is calculated by using information for other overseas companies. if there are pure play proxy firm, which is a company that operates in the country of the multinational’s overseas division, is in a similar line of business and has observable equity returns with which to estimate equity beta. Then we could use the pure play as a proxy for the division.

40. Pure Play Proxy Method.. To estimate the equity beta of the pure play from the US dollar perspective, we convert the local currency returns of the pure play into US dollar returns using (1+R $ ) = (1+R € )*(1+x $/€ ). Then regress $ return to the global market index in US dollars. Then use the above equation to convert $ cost of capital into euro cost of capital..