Global Cost of Capital and Financial Structure

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Global Cost of Capital and Financial Structure

International Financial Management
Dr. A. DeMaskey
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Learning Objectives

• What is a firms cost of capital?
• How is the cost of capital for foreign
  investments determined?
• What key issues are involved in applying the CAPM
  to estimating the cost of equity capital for
  foreign projects?
• How is the effective dollar cost of debt
  determined?
• What should be the MNCs worldwide capital
  structure?

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Weighted Average Cost of Capital

• WACC wdkd(1 - T) weke
• where wi proportion of source of capital
  used in the capital structure ki
  marginal cost of source of capital
• T corporate tax rate.

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The Cost of Equity Capital

• The CAPM Approach
• ks kRF (kM - kRF)bi
• where (kM kRF)bi risk premium
• bi systematic risk
• kM kRF market risk premium

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Beta Coefficient

• Beta is the measure of systematic risk for asset
  i, which is computed as
• Where ?im correlation between asset i and the
  market
• si standard deviation of
  returns on asset i
• sm standard deviation of returns on
  the market
• portfolio

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The Cost of Debt Capital

• Cost of debt requires
• Interest rate forecast for next few years
• Proportion of various classes of debt the firm
  expects to use
• Corporate income tax rate
• Effective cost of debt
• kd kd (1 T)

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The Weighted Average Cost of Capital for Foreign
Projects

• If project risk and financial structure for a
  foreign project varies from the corporate norm,
  the costs and weights of the different cost
  components must be adjusted to reflect their
  actual values.
• The projects WACC will equal
• WACC wdkd(1 - T) weke

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Key Issues in Estimating Foreign Project Discount
Rates

• Should the corporate proxies be U.S. or local
  companies?
• Is the relevant base portfolio against which the
  proxy beta are estimated the U.S. market
  portfolio, the local portfolio, or the world
  market portfolio?
• Should the market risk premium be based on the
  U.S. market or the local market?
• How should country risk be incorporated in the
  cost of capital estimates?

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Proxy Companies

• Local Companies
• Proxy Industries
• Adjusting U.S. Industry Beta

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The Relevant Base Portfolio

• Home Market Portfolio
• ri rf bius (rus rf)
• Global Capital Asset Model
• ri rf big (rg rf)
• where

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The Relevant Market Risk Premium

• U.S. Market Risk Premium
• Mostly U.S. investors
• Foreign betas should be estimated relative to the
  U.S. market
• Statistical validity of U.S. capital market data

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Estimating the Equity Cost of Capital for the
Foreign Subsidiary

• Find proxy portfolio in country in which
  subsidiary operates
• Calculate beta relative to U.S. market
• Multiply beta by the risk premium for U.S. market
• Add estimated equity risk premium for foreign
  subsidiary to U.S. riskfree rate

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The Cost of Debt Capital

• Dollar cost of LC loan
• rL (1 c) c
• After-tax dollar cost of LC loan
• rL (1 c)(1 ta) c
• Multiyear LC loan
• Without taxes
• With taxes

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Establishing a Worldwide Capital Structure

• Consolidated worldwide capital structure
• Optimal global financing plan
• Cost and availability of other sources
• Worldwide debt ratio
• Default risk
• Target capital structure

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Subsidiary Capital Structure Funding Sources

• Parent raises capital in home country and invests
  these funds as equity
• Subsidiary debt ratio is zero
• Parent invests one dollar of share capital in
  subsidiary and requires all to finance operations
  on its own
• Subsidiary debt ratio is 100
• Parent borrows funds and relends monies as an
  intercorporate loan to subsidiary
• Subsidiary debt ratio is 100

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Subsidiary Financial Structure

• Subsidiary financial structure is not
  independent.
• Debt/equity ratio of subsidiary is irrelevant
• Focus is on worldwide capital structure
• Vary subsidiary capital structure to take
  advantage of local financing opportunities

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Foreign Subsidiary Capital Structure

• Conform to that of the parent company
• Reflect the capitalization norms in each foreign
  country
• Vary to take advantage of opportunities to
  minimize the parent firms cost of capital

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Cost of Capital for MNCs versus Domestic Firms

• Is the WACC or an MNC higher or lower than for
  its domestic counterpart? The answer is a
  function of
• The marginal cost of capital
• The after-tax cost of debt
• The optimal debt ratio
• The relative cost of equity
• An MNC should have a lower cost of capital
  because it has access to a global cost and
  availability of capital
• This availability and cost allows the MNC more
  optimality in capital projects and budgets
  compared to its domestic counterpart