1. International Cost of Capital
(or chapter 11)

2. Agenda Weighted average cost of capital?
How to find international cost of equity?
Market liquidity/segmentation & cost of capital?
MNE vs. domestic counterpart WACC?

3. Weighted Average Cost of Capital
kWACC = weighted average cost of capital, WACC
ke = risk adjusted cost of equity
kd = before-tax cost of debt
t = tax rate
E = market value of equity
D = market value of debt
V = market value of firm (D+E)

4. International Cost of Equity
How to estimate? Many approaches:
World CAPM (W. Sharpe).
Segmented/Integrated CAPM (G. Bekaert & C. Harvey).
Goldman Sachs - integrated.
A.Damodaran’s method.

5. World CAPM
Intuition: required rate of return depends on how investment contributes to volatility of well diversified portfolio.
Expected return (in US$) on investment
= risk-free rate + b x world risk premium.
Beta (b) measured relative to “world” portfolio.
What is beta?
Shows degree of “co-movement”
Model assumption: perfect market integration.
OK for developed markets (if allow risk to vary through time).
Gives unreliable results in smaller/illiquid developed markets.
Fails in emerging markets.

6. Source: Cam Harvey’s web site @ http://www.fuqua.duke.edu
World CAPM Failure
Wrong risk / return relation !!
Source: Cam Harvey’s web

7. Segmented/Integrated CAPM
CAPM assumes perfect integration. Markets oftentimes aren’t!
STEPS
Estimate world beta & expected return = world CC
= risk-free + bW x world risk premium.
Estimate local beta & expected return = local CC
= local risk-free + bL x local risk premium.
Put two in common currency terms.
Add up two components:
CC = w * [world CC] + (1-w) * [local CC]
Weight w, determined by proxies for degree of integration: size of international trade & [equity market capitalization/GDP]
Downside: appropriate for countries w/ equity markets.

8. Goldman Sachs-Integrated*
CAPM gives low expected return, so add sovereign yield spread.
Idea: Default risk premium correlated w/ equity risk premium.
Sovereign yield spread: yield on US$ bond a country offers vs. US T-bond of same maturity.
Spread reflects “country risk”
STEPS
Estimate market beta on S&P 500.
Get beta times historical US equity premium.
Add sovereign yield spread plus risk free to get equity risk premium.
Useful if you have sovereign yield spread.
Model used by McKinsey, Salomon & others.
*J.Mariscal & R. Lee, “Valuation of Mexican Stocks: An extension of the capital
asset pricing model to emerging markets”, Goldman Sachs, 1993.

9. Source: Ibbotson Associates
Equity Risk Premium
Source: Ibbotson Associates

10. Source: Ibbotson Associates

11. Cost of Equity & Debt: CAPM example
Cost of equity: calculate using Capital Asset Pricing Model (CAPM)
Where
ke = expected rate of return on equity
krf = risk free rate on bonds
km = expected rate of return on market
β = coefficient of firm’s systematic risk
Cost of debt: analyze proportions of various debt & their associated interest rates & calculate before- & after-tax weighted average cost of debt.

12. CAPM example A company headquartered in US
Use US as base for market & equity risk calculation
kWACC = weighted average cost of capital
ke = Cost of equity is 17%
kd = Before-tax cost of debt is 8%
t = tax rate of 35%
E/V = equity-to-value ratio 60%
D/V = debt-to-value ratio 40%

13. Market Liquidity & Segmentation
Market liquidity: degree to which firm can issue new securities without depressing existing market prices.
Market illiquidity & segmentation influence marginal cost of capital
Market Segmentation: claims w/ same expected return & risk class have different rates of return even after accounting for forex & political risks.
Caused by:
Asymmetric information
High transaction costs
Corporate governance practices
Regulatory barriers

14. Liquidity/Segmentation & MCC*
Budget
($million)
Marginal cost of capital &
Marginal rate of return
(%) 10 20 30 40 50 60
20%
15%
13%
10%
MNE from illiquid & segmented market
MNE from illiquid market
Domestic
MRR
MCCF kF
MCCU kU kD
MCCD
* Marginal Cost of Capital

15. MNE vs. domestic WACC Empirical studies have found that:
MNE has lower debt/equity ratio
MNE has higher systematic risk!
Hidden Actions of Managers (Agency Costs)
Asymmetric (Hidden) Information
Political Risk
Forex Risk
So: MNE WACC could be > WACC domestic.
But: MNE tend to be mature firms that follow pecking order
i.e. they use
internal cash
Debt
& rarely new equity
Why? Equity is information sensitive!!!

16. Is MNE WACC < domestic WACC?
Theory: MNE should have low cost & abundant capital.
Budget
($m)
Marginal cost of capital (%)
100
140
300
350
400
15%
10% 5%
20%
Large
Set of Projects
MCCDC
Small
Set of Projects
MRRMNE
MRRDC
MCCMNE

17. But…a few unsettling facts…[
kWACC = ke
Equity
Value
+ kd ( 1 – tax )
Debt ]
MNEWACC >?< DomesticWACC
Required cost of equity higher for MNE (Political risk, forex risk, high agency costs).
=> At high levels of capital budget, MNE has lower cost of capital.
MNE: lower cost of debt => lower cost capital.
MNE: lower debt/capital ratio => higher cost capital.

18. Things to remember… Weighted average cost of capital?
How to find international cost of equity?
Market liquidity/segmentation & cost of capital?
MNE vs. domestic WACC?