Ch 16: International Capital Structure and the Cost of Capital

1
Ch 16 International Capital Structure and the
Cost of Capital

• Capital structure of MNEs will not be the same as
  for purely domestic enterprises.
• Markets are not fully integrated.
• Underlying issues
• Barriers preventing free flow of capital across
  borders.
• Arbitrage opportunities exist.

2
Cost of Capital

• Most basic issue determining corporate
  investment.
• Companies will undertake investment iff NPV gt 0.
  
• Easy benchmark internal rate of return vs. cost
  of capital.
• Definition Cost of capital is the minimum rate
  of return an investment project must generate to
  cover the associated financing costs.

3
Cost of Capital (2)

• Definition A levered firm is a firm that has
  issued debt and equity (vs. unlevered or all
  equity).
• For a levered firm, the financing costs can be
  represented by the weighted average cost of
  capital.

4
Weighted Average Cost of Capital

• Where
• K weighted average cost of capital
• Kl cost of equity capital for a levered firm
• i pretax cost of debt
• ? marginal corporate income tax rate
• debt to total market value ratio
• ? Weighted Average Cost of Capital ( of MV
  that is equity) (Cost of Equity) ( of MV
  that is debt) (Cost of Debt adjusted for taxes)

5
How the Cost of Capital Impacts Corporate
Investment Decisions

• If a firm can decrease the cost of capital, it
  can make more investments.
• This increases the firms potential profits.
• Internationalizing the firms cost of capital is
  one such policy.

cost of capital ()
K local
K global
IRR
Investment ()
Ilocal Iglobal
6
Effect of Market Structure on Cost of Capital

• If markets are segmented, then the markets dont
  clear naturally. This distortion means that
  segmented markets will yield higher cost of
  capital.
• The cost of equity capital (Ke) of a firm is the
  expected return on the firms stock that
  investors require.

7
Extend CAPM

• Estimate the return using CAPM
• where
• If the markets are segmented, use
• and
• This shows that integration/segmentation of
  international financial markets has major
  implications for determining the cost of capital.

8
Does the Cost of CapitalVary Internationally?

• If the cost of capital were the same in all
  countries then .
• But empirical evidence indicates that the cost of
  capital does vary across countries.
• So
• When markets are imperfect, international
  financing can lower the firms cost of capital.
• One way to achieve this is to internationalize
  the firms ownership structure.

9
Cross-Border Listings of Stocks

• Cross-border listings of stocks have become quite
  popular among major corporations.
• The largest contingent of foreign stocks are
  listed on the London Stock Exchange.
• U.S. exchanges have attracted the next largest
  contingent of foreign stocks.

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Cross-Border Listings of Stocks

• Cross-border listings of stocks benefit a
  company
• Expand potential investor base ? lead to a higher
  stock price and lower cost of capital.
• Creates a secondary market for the companys
  shares, ? facilitates raising new capital in
  foreign markets.
• Enhance the liquidity of the companys stock.
• Enhances the visibility of the companys name and
  products in foreign marketplaces.

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Cross-Border Listings of Stocks

• Cross-border listings of stocks do carry costs.
• It can be costly to meet the disclosure and
  listing requirements imposed by the foreign
  exchange and regulatory authorities.
• Once a companys stock is traded in overseas
  markets, there can be volatility spillover from
  these markets.
• Once a companys stock is make available to
  foreigners, they might acquire a controlling
  interest and challenge the domestic control of
  the company.

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Capital Asset Pricing Under Cross-Listings

• Recall the definition of beta

We can recalibrate the CAPM formula
As
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Capital Asset Pricing Under Cross-Listings

• We can develop a measure of aggregate risk
  aversion, AM

• We can restate the CAPM using AM

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Capital Asset Pricing Under Cross-Listings

• This equation indicates that, given investors
  aggregate risk-aversion measure, the expected
  rate of return on an asset increases as the
  assets covariance with the market portfolio
  increases.
• In fully integrated capital markets, each asset
  will be priced according to the world systematic
  risk.

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Capital Asset Pricing Under Cross-Listings

• The International Asset Pricing Model (IAPM)
  above has a number of implications
• International listing of assets in otherwise
  segmented markets directly integrates
  international capital markets by making these
  assets tradable.
• Firms with nontradable assets essentially get a
  free ride from firms with tradable assets in the
  sense that the former indirectly benefit from
  international integration in terms of a lower
  cost of capital.

16
The Effect of Foreign Equity Ownership
Restrictions

• While companies have incentives to
  internationalize their ownership structure to
  lower the cost of capital and increase market
  share, they may be concerned with the possible
  loss of corporate control to foreigners.
• In some countries, there are legal restrictions
  on the percentage of a firm that foreigners can
  own.
• These restrictions are imposed as a means of
  ensuring domestic control of local firms.

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The Financial Structure of Subsidiaries

• Three approaches
• Conform to the parent company's norm.
• Conform to the local norm of the country where
  the subsidiary operates.
• Vary structure by location to reflect local
  conditions that generate opportunities to
• lower taxes,
• reduce financing costs and risk, and
• take advantage of various market imperfections.
• ? Must also consider political risk.

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Political Risk
August 2002 Argentina 58.0 China
66.0 Dominican Rep 66.5 Germany 86.0 Greece
76.5 Hong Kong 79.5 India 56.0 Iraq
37.0 Italy 81.0 Japan 85.5 Mexico
68.0 Russia 66.0 Sweden 92.0 Taiwan 77.0 UK
88.0 US 76.5 Venezuela 49.0

• International Country Risk Guide provides monthly
  data for 140 countries.
• Political risk (100)
• Government stability (12)
• Socioeconomic conditions (12)
• Investment profile (12)
• Internal conflict (12)
• External conflict (12)
• Corruption (6)
• Military in politics (6)
• Religious tensions (6)
• Law and order (6)
• Ethnic tensions (6)
• Democratic accountability (6)
• Bureaucracy quality (4)

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Ch 17 Review of Domestic Capital Budgeting

• 1. Identify the size and timing of all relevant
  cash flows on a time line.
• 2. Identify the riskiness of the cash flows to
  determine the appropriate discount rate.
• 3. Find NPV by discounting the cash flows at the
  appropriate discount rate.
• 4. Compare the value of competing cash flow
  streams at the same point in time.

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Review of Domestic Capital Budgeting

• The basic net present value equation is

Where CFt expected incremental after-tax cash
flow in year t, TVT expected after tax cash
flow in year T, including return of net working
capital, C0 initial investment at inception, K
weighted average cost of capital. T economic
life of the project in years.
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Review of Domestic Capital Budgeting

• The NPV rule is to accept a project if NPV ? 0

and to reject a project if NPV lt 0
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Review of Domestic Capital Budgeting

• For our purposes it is necessary to expand the
  NPV equation

Rt is incremental revenue OCt is incremental
operating cash flow Dt is incremental
depreciation It is incremental interest expense
? is the marginal tax rate
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Review of DomesticCapital Budgeting
This means The cash flow in year t the nominal
after-tax incremental cash flow from year t.
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Review of Domestic Capital Budgeting

• We can use

to restate the NPV equation
as
25
The Adjusted Present Value Model

• Can be converted to adjusted present value (APV)

By appealing to Modigliani and Millers results.
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The APV Model (2)

• The APV model is a value additivity approach to
  capital budgeting. Each cash flow that is a
  source of value to the firm is considered
  individually.
• Note that with the APV model, each cash flow is
  discounted at a rate that is appropriate to the
  riskiness of the specific cash flow.

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Capital Budgeting from the Parent Firms
Perspective

• Lessard developed an APV model for a MNE
  analyzing a foreign capital expenditure. This
  model incorporates many features that are
  distinctive to foreign direct investment.

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Capital Budgeting from the Parent Firms
Perspective

• The operating cash flows must be translated back
  into the parent firms currency at the spot rate
  expected to prevail in each period.

The operating cash flows must be discounted at
the unlevered domestic rate
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Capital Budgeting from the Parent Firms
Perspective

• OCFt represents only the portion of operating
  cash flows available for remittance that can be
  legally remitted to the parent firm.

The marginal corporate tax rate, ?, is the larger
of the parents or foreign subsidiarys.
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Capital Budgeting from the Parent Firms
Perspective

• S0RF0 represents the value of accumulated
  restricted funds (in the amount of RF0) that are
  freed up by the project.

Denotes the present value (in the parents
currency) of any concessionary loans, CL0, and
loan payments, LPt , discounted at id .
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Step 1 Estimating the Future Expected Exchange
Rates

• We can apply PPP
• Note This may not be 100 realistic but it is
  the best tool to use unless you have more
  concrete information to rely upon.

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International Capital Budgeting
A recipe for international decision makers 1.
Estimate future cash flows in foreign
currency. 2. Convert to U.S. dollars at the
predicted exchange rate. 3. Calculate APV using
the U.S. cost of capital.
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International Capital Budgeting

• Facts

Is this a good investment from the perspective of
the U.S. shareholders?
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International Capital Budgeting
Similarly,
APV -331.60 113.7/(1.15) 292.6/(1.15)2
180.7/(1.15)3 107.3 gt 0
so accept.
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In-Class Example

• Assume
• I 7 ? 2 ? 0.5
• S0(/) 118 ? S0(/) 1/118?.0085

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In-Class Example (2)

• Calculate the expected exchange rate in years 1,
  2 and 3.
• Calculate the Cash Flow in years 0, 1, 2, and 3.
• Calculate the APV given CF0, CF1, CF2, CF3, and
  the US inflation rate.
• Note were assuming the interest rate and
  inflation rates are constant during this period.
• Should the firm make this investment?

37
Risk Adjustment in the Capital Budgeting Process

• Risk and return are often highly correlated.
• Moreover, political risk may accompany business
  risk. This could force an adjustment in the
  discount rate.

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Sensitivity Analysis

• In the APV model, each cash flow has a
  probability distribution associated with it.
• Hence, the realized value may be different from
  what was expected.
• In sensitivity analysis, different estimates are
  used for expected inflation rates, cost and
  pricing estimates, and other inputs for the APV
  to give the manager a more complete picture of
  the planned capital investment.

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Real Options

• The application of options pricing theory to the
  evaluation of investment options in real projects
  is known as real options.
• A timing option is an option on when to make the
  investment.
• A growth option is an option to increase the
  scale of the investment.
• A suspension option is an option to temporarily
  cease production.
• An abandonment option is an option to quit the
  investment early.