International Capital Structure and the Cost of Capital

1

• International Capital Structure and the Cost of
  Capital
• (chapter 16)

2
Cost of Capital

• The cost of capital is the minimum rate of return
  an investment project must generate in order to
  pay its financing costs.
• For a levered firm, the financing costs can be
  represented by the 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
• debt to total market value ratio
• ? tax rate

3
The Firms Investment Decision and the Cost of
Capital

• A firm that can reduce its cost of capital will
  increase the profitable capital expenditures that
  the firm can take on and increase the wealth of
  the shareholders.
• Internationalizing the firms cost of capital is
  one such policy.

cost of capital ()
K local
K global
IRR
Investment ()
Ilocal Iglobal
4
Cost of Capital in Segmented vs. Integrated
Markets

• The cost of equity capital (Ke) of a firm is the
  expected return on the firms stock that
  investors require.
• This return is frequently estimated using the
  Capital Asset Pricing Model (CAPM)

where
5
Cost of Capital in Segmented vs. Integrated
Markets
If capital markets are segmented, then investors
can only invest domestically. This means that the
market portfolio (M) in the CAPM formula would be
the domestic portfolio instead of the world
portfolio.
versus
Clearly integration or segmentation of
international financial markets has major
implications for determining the cost of capital.
6
Example Cost of capital for Nestle
Nestle, is a the Swiss-based MNC that produces
and distributes a variety of food products. Rf
3.3 RSZ 10 ?N-SZ 0.885 RW 11 ?N-W
0.585 Assume that Nestle pays 4 for its debt
has a debt/total capitalization ratio of 0.35
and pays a tax rate of 20. Calculate the cost
of equity capital for Nestle assuming the (i)
Swiss market is segmented, and (ii) Swiss market
is perfectly globally integrated Calculate
Nestles WACC , considering the Swiss market is
globally integrated.
7
Exam type question

• Royal Dutch Petroleum, a large multinational
  corporation, has an equity market value of 100
  billion dollars and a value of its outstanding
  debt estimated at 30 billion dollars. The equity
  beta for Royal Dutch, based on the world market
  index, is 1.1 the risk free rate is 3 and the
  expected return on the world market index is 10.
  The corporate tax rate is 40 and the cost of
  debt capital is 6. Calculate Royal Dutchs
  weighted average cost of capital.
• Answer The debt weight is 0.3 (30b./100b.) and
  the equity weight is 0.7.
• Kl Rfbeta(Rw-Rf)31.1(10-3)10.7
• WACC 0.710.70.3(1-0.4)6 8.57

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Does the Cost of Capital Differ among Countries?

• There do appear to be differences in the capital
  structure and cost of capital across countries
• Companies from developed markets where banking
  sector plays a more important role than public
  markets have larger debt/equity ratios and lower
  cost of capital
• When markets are imperfect, international
  financing can lower the firms cost of capital.

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Cross-Border Listings of Stocks

• Firms operating in segmented markets(e.g. small
  and illiquid capital markets emerging markets)
  can raise new capital and lower their cost of
  capital by cross- listing their stock on large,
  liquid markets
• Cross-Listing refers to a firm having its equity
  shares listed on one or more foreign exchanges.
• 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 and U.S.
  exchanges

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Cross-Border Listings of Stocks

• Cross-border listings of stocks benefit a company
  in the following ways.
• The company can expand its potential investor
  base, which will lead to a higher stock price and
  lower cost of capital.
• Cross-listing creates a secondary market for the
  companys shares, which facilitates raising new
  capital in foreign markets.
• Cross-listing can enhance the liquidity of the
  companys stock.
• Cross-listing enhances the visibility of the
  companys name and its 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 made available to
  foreigners, they might acquire a controlling
  interest and challenge the domestic control of
  the company.

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• The following sections in chapter 16 are not
• required for the exam
• - Capital asset pricing under cross-listings
• Asset Pricing under foreign ownership
  restrictions
• The financial structure of the subsidiary

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Learning outcomes

• Know how to calculate a MNCs costs of equity
  capital (using both domestic index and world
  index) and WACC (see the example on slides 6 and
  7)
• Suppose that your firm is operating in a
  segmented capital market. What actions do you
  recommend to mitigate the negative effects?
• Does the cost of capital differ across
  countries?
• Explain the benefits for a firm that
  cross-lists.
• Explain the costs for a firm that cross-lists.
• Explain why a firms cost of capital may
  decrease when the firms stock is cross-listed
  abroad
• Recommended end-of-chapter questions 1, 2 and 9