1. The Cost of Capital for Foreign Investments P.V. Viswanath International Corporate Finance

2. P.V. Viswanath2 Learning Objectives  How Capital Budgeting can differ in an international context  What is the traditional notion of Cost of Capital?  How do we estimate the cost of equity and the cost of debt in a domestic context?  What is the relevance of who “owns” the company?  How do we use proxy companies in estimating cost of equity?  What is the relevance of country risk?  How do we estimate country risk?

3. P.V. Viswanath3 Capital Budgeting for Foreign Investments  Capital Budgeting in an international environment raises issues that are not present in a domestic setup. Cashflows depend on capital structure because of cheap loans from foreign governments. This makes the cost of capital to the corporation different from the opportunity cost of capital for shareholders. There are exchange-rate risks, country risks, multiple tiers of taxation, and sometimes restrictions on repatriating income.  In principle many of these issues can be resolved using an adjusted present value approach, where the project is valued as a stand-alone all equity project and impact of the the different financing frictions are added to this base value.  However, in practice, most firms use a NPV/IRR approach. Hence we shall focus on computing the right cost of capital to evaluate projects.

4. P.V. Viswanath4 The cost of capital  In what follows, we will assume that the subsidiary or project cashflows have been restated in dollars. Hence the issue is coming up with a discount rate that is appropriate for dollar flows.  One implication of this is that the correct riskfree rate to use is a Treasury rate.  In principle, the cost of capital used should be a forward- looking rate. However, in practice, the components of the cost of capital are often estimated using historical data.  While this is unavoidable, historical estimates should be used with care.

5. P.V. Viswanath5 The WACC  If the financial structure and risk of a project is the same as that of the entire firm, then the appropriate discount rate is the Weighted Average Cost of Capital: WACC = k e (1-d) + i d (1-t)d  where d = the firm’s debt-to-assets ratio (debt ratio) i d = before-tax cost of debt k e = cost of equity t = marginal tax rate of the firm  In using the WACC for project selection, the value of d used must be the target debt ratio.  If the risk of a project is different, then it should be evaluated using its own beta, and its own target debt-to-assets ratio, etc.

6. P.V. Viswanath6 The cost of equity  According to the CAPM, the required rate of return on an asset is given as: R f = risk-free rate  i = beta of asset i, a measure of its non-diversifiable risk.  In principle, the CAPM applies to all assets, but in practice – It is used to estimate the cost of equity It is rarely used to estimate the cost of debt because it is very difficult to estimate a beta for debt securities.

7. P.V. Viswanath7 The cost of debt  In practice, the yield-to-maturity is used instead of the required rate of return, for debt securities.  Where the bond is not traded, and hence no implied yield-to-maturity can be computed, firm-specific variables, such as interest-coverage ratios are used to generate synthetic bond ratings.  Historical relationships between bond-ratings and bond spreads over Treasuries are then used to come to an estimate of the bond's yield-to-maturity.

8. P.V. Viswanath8 Cost of Equity for foreign projects  If the firm's equity investors hold a diversified US portfolio, then the beta should be computed for the new project with respect to the US equity index (market portfolio) and the required rate of return can be computed using the CAPM, even though the project may be a foreign project.  If the "US" firm's investors are really holding a globally diversified portfolio, or if they are not restricted to the US (and hence, once again, they hold globally diversified portfolios), then it makes sense to compute an equity cost of capital for them by using the global CAPM, i.e. computing the beta for the new project using the global "market" portfolio (and a global risk premium).

9. P.V. Viswanath9 Cost of Equity for foreign projects  However, in practice, US investors may not be globally diversified, and It may be easier to obtain US data than global data  Consequently, US MNEs often evaluate projects from the viewpoint of a US investor, who is not diversified internationally.  Furthermore, a recent study (2004) showed that a cost of capital estimated using a domestic CAPM model is insignificantly different from a cost of capital computed using global risk factors.

10. P.V. Viswanath10 Issues in estimating cost of capital for foreign projects  In order to estimate a beta for the foreign subsidiary, a history of returns is required. Often this is not available. Hence, a proxy may have to be used, for which such information is available. Should corporate proxies be local companies or US companies?  The beta is the estimated slope coefficient from a regression of the stock returns against a base portfolio, which is the global market portfolio, according to the CAPM. However, this assumes that markets are integrated. In practice, is the relevant base portfolio against which proxy betas are to be estimated, the US market portfolio, the local portfolio, or the world market portfolio? Should the market risk premium be based on the US market or the local market or the world market?  How should country risk be incorporated in the cost of capital?

11. P.V. Viswanath11 Using Proxy Companies to estimate beta  Since we want a proxy as similar as possible to the project in question, it makes sense that we use a local company.  The return on an MNC’s local operations will depend on the evolution of the local economy.  Using a US proxy is likely to produce an upward biased estimate for the beta.  This can be seen by looking at the definition of the foreign market beta with respect to the US market:  Foreign companies are likely to have lower correlation with the US market than US companies.

12. P.V. Viswanath12 Using Proxy Companies to estimate beta  If foreign proxies in the same industry are not available (say because of data issues), then a proxy industry in the local market can be used, whose beta is expected to be similar to the beta of the project’s US industry.  Alternatively, compute the beta for a proxy US industry and multiply it by the unlevered beta of the foreign country relative to the US. This will be valid, if: The US beta for the industry is the same as that of that industry in the foreign market as well, and The only correlation, with the US market, of a foreign company in the project’s industry is through its correlation with the local market and the local market’s correlation with the US market.

13. P.V. Viswanath13 The Relevant Market Risk Premium  Although, in principle, it may be appropriate to use a global market portfolio, in practice, we use the US market portfolio, for several reasons: the small amount of international diversification of US investor portfolios since US projects are evaluated using a US base portfolio, use of a US base portfolio means that foreign projects can be easily compared to a US project.  Correspondingly, a market risk premium based on the US market is used, as well.  US markets have much more historical data available, and it is a lot easier to estimate forward-looking risk premiums for the US market. However, the US market risk premium is often adjusted to take country risk premiums into account.

14. P.V. Viswanath14 Country Risk Premiums  The previous approaches that use US base portfolios and/or US proxies effectively ignore country risk, assuming that it is diversifiable. However, this may not be the case. In fact, with globalization, cross-market correlations have increased, leading to less diversifiability for country risk.  Furthermore, it may not be enough to look at the beta alone of a foreign project's beta, because this only deals with contribution to volatility.  Skewness or catastrophic risk may be significant in the case of emerging markets. The impact of a project on the negative skewness of the equityholder's portfolio could be significant and should be taken into account.

15. P.V. Viswanath15 Country Risk Premiums  For example, India's beta could be negative, but it would not be appropriate to discount Indian projects at less than the US risk-free rate.  If investors do not like negative skewness (i.e. the likelihood of catastrophic negative returns), we should augment the CAPM with a skewness term.  An alternative would be to estimate a country risk premium based on the riskiness of the country relative to a maturity market like the US, and to incorporate this into the cost of equity of the project.

16. P.V. Viswanath16 Estimating Country Premiums  Country Premiums may be estimated by looking at the rating assigned to a country’s dollar-denominated sovereign debt.  One can then look at the spread over US Treasuries or a long-term eurodollar rate for countries with such ratings (sovereign risk premium). This spread would be a measure of the country risk premium.  One could also look at the spread for US firms’ debt with comparable ratings.  Optionally, one might then adjust this spread by the ratio of the standard deviation of equity returns in that country to the standard deviation of bond returns – to convert a bond premium to an equity premium.

17. P.V. Viswanath17 Using the Country Premium  The country risk premium that is obtained can then be used in two ways: One, it could be added to the cost of equity of the project. This assumes that the country risk premium applies fully to all projects in that country Two, one could assume that the exposure of a project to the country risk is proportional to its beta. In this case, one would add the country risk premium to the US market risk premium to get an overall risk premium. This would then be multiplied by the beta as before to obtain the project-specific risk premium.

18. P.V. Viswanath18 Using the Country Risk Premium  Finally, one could take the US market risk premium and multiply it by the ratio of the volatility of stock returns in the foreign country to the volatility of stock returns in the US.  This is the country-risk adjusted market risk premium.  As before, then, this market risk premium would be multiplied by the beta of the project to get the project-specific risk premium.

19. P.V. Viswanath19 Adjusting for Country Risk  Suppose the market risk premium in US markets is 5.5%  The yield on US 10 year treasuries is 5%  The yield on German government bonds is 6%  The world nominal risk-free rate (computed as the lowest risk-free rate that can be obtained globally, for borrowing in dollars – or otherwise adjusted for exchange rate risk) is also assumed to be 5%.

20. P.V. Viswanath20 Adjusting for Country Risk  Project beta with respect to US market is 1.0  Project beta with respect to an international equity index is 1.1  The beta of the German market with respect to the US market portfolio is 1.2.  The volatility of returns (std devn) on a broad-based US market index is 25% per year.  The volatility of returns on a broad-based German index is 35% per year.  The volatility of returns on a broad-based world index is 30% (returns measured in dollars)

21. P.V. Viswanath21 Adjusting for Country Risk  Reqd. ROR = US Riskfree rate +  i (Market Risk Premium)  If the investors in the project are investors who hold domestic (US) diversified portfolios, then we use US quantities. Suppose country risk is diversifiable or can otherwise be ignored: Reqd ROR = 5% + 1 (5.5) = 10.5%, and country risk premium is set at zero.  If the investors are internationally diversified, and country risk can be ignored, Reqd ROR = 5% + 1.1 (5.5) = 11.05%, and country risk premium is set at zero.  If we take a weighted average of the two rates (in this example, we use 65-35 weights), we get 0.65(10.5) + (0. 35)(11.05) = 10.6925%

22. P.V. Viswanath22 Adjusting for Country Risk  If we believe that country risk is not diversifiable and/or is not otherwise captured in the beta computation or that it captures other kinds of risk that go beyond variability risk, we need to adjust for country risk.  Add sovereign risk premium to the required rate of return: (If we are worrying about country risk premiums, we’re probably discounting the existence of a single international asset pricing model, since it implies an integrated world.)  In this case, the risk-free rate in Germany is 8%, which is greater than the US 10 year treasury yield of 5% by 100 bp.  This gives us a cost of equity capital of 5% + (6 - 5) + 1(5.5) = 11.5%

23. P.V. Viswanath23 Adjusting for Country Risk  If we assume that the country risk premium is shared by the project only to the extent that it moves with the market, then we’d get Required ROR = 5% + 1(5.5 + 1) = 11.5% (in this case, the rate doesn’t change from the approach above, since the beta is 1).  If we say that the country risk premium is shared by the project only to the extent that it moves with its local market: Reqd ROR = 5% + 1 (5.5) + (1.2)(1) = 14.1%, where the 1.2 is the beta of the German market w.r.t. the US market portfolio.  Amplifying CAPM beta by volatility ratio: Amplified beta = 1x(35/30) Hence the required rate of return is = 5% + 1(35/30)(5.5) = 11.42%

24. P.V. Viswanath24 Computing cost of debt on foreign- currency loans  Suppose Alpha S.A., a French subsidiary of a US firm borrows €10m. for 1 year at an interest rate of 7%. If the current rate is $0.87/€, this would be a $8.7m. loan.  If the end-of-year rate is expected to be $0.85/€, the dollar cost of the loan is only 4.54%, since (10.7)(0.85)/8.7 = 1.0454.  In general, the dollar cost of a foreign currency loan with an interest rate of r L and a depreciation of the home currency of c% per year is given by r L (1 + c) + c.  If the loan is taken by a foreign subsidiary and the interest can be deducted for tax purposes, where the tax rate is t a, then the effective dollar rate is r = r L (1+c)(1 ‑ t a ) + c.

25. P.V. Viswanath25 The Cost of Debt Capital  In general, the effective dollar interest rate is, r, where: c is the annual rate of appreciation of the local currency r L is the coupon rate of the loan t a is the affiliate’s marginal tax rate  However, the solution to this general problem is the same as the solution to the single period problem.  Finally, we put the cost of debt and the cost of equity together to get the WACC.

26. P.V. Viswanath26 Problem: Cost of debt capital  IBM is considering having its German affiliate issue a 10-year $100m. bond denominated in euros and priced to yield 7.5%. Alternatively, IBM’s German unit can issue a dollar-denominated bond of the same size and maturity and carrying an interest rate of 6.7%.  If the euro is forecast to depreciate by 1.7% annually, what is the expected dollar cost of the euro-denominated bond? How does this compare to the cost of the dollar bond?

27. P.V. Viswanath27 Problem: Cost of debt capital  The pre-tax $ cost of borrowing in euros at a interest rate of r L, if the euro is expected to depreciate against the dollar at an annual rate of c, is r L (1 + c) + c. There is a “depreciation penalty applied to the interest (first term) and to the principal (second term).  In this case, we get an expected $ cost of borrowing euros of 7.5(1-0.017)-1.7 or 5.67. This is below the 6.7% cost of borrowing $s.  If the German unit is taxed at t a, the t a, is r = r L (1+c)(1 ‑ t a ) + c. Thus, if t a = 35%, r = 7.5(1-0.017)(1-0.35) - 0.017, or 4.78%.

28. P.V. Viswanath28 Differentials in Cost of Funds for foreign projects  What if funds are available to finance foreign projects at below-market costs?  Suppose a foreign subsidiary requires $I of new financing for a project as follows: $P from the parent, $E f from the subsidiary’s retained earnings, $D f from foreign debt.  Suppose the cost of retained earnings for the subsidiary is k s versus the general cost of equity for the parent, k e, and that the cost of debt financing after-tax for the subsidiary is i f versus the after-tax cost of debt for the parent of i d (1-t).

29. P.V. Viswanath29 Cost of foreign project  Then the total cost of financing the project in dollars is: Ik I = Ik o - E f (k e - k s ) - D f [i d (1-t) - i f ]  Simplifying, we find that the WACC for the new project, k I equals: k I = k o - a (k e - k s ) - b[i d (1-t) - i f ] where k o = cost of capital of the parent k s = cost of retained earnings for the subsidiary i f = the after-tax cost of foreign debt a = E f /I b = D f /I