International Financial

Management
International Capital Structure and the
Cost of Capital
Cost of Capital
The cost of capital is the minimum rate of
return an investment project must generate to pay
its financing costs.
If the return on an investment project is equal to
the cost of capital, undertaking the project will
leave the firms value unaffected.
Cost of Capital
When a firm identifies and undertakes an
investment project that generates a return
exceeding its cost of capital, the firms value will
increase.
It is thus important for a value maximizing firm
to try to lower its cost of capital.
Cost of Capital and MN Firm
The cost of capital for MN firms may be affected
through two distinct channels:
Global operations may make the firm more or less
risky and thus affect the expected returns of
capital contributors.
Financing the firm globally (taking on a global
capital structure), especially in lower financing
cost markets, may affect the firms overall cost of
capital.
Globalizing the Firms Markets
As a firm moves from a domestic setting to a global
setting, its cost of capital is likely to change as
capital contributors view the impact of the firms
global expansion on the risk level of the firm.
Is the firm taking on more risk?
Is the firm taking on less risk, or making itself
less risky as a result of its global expansion?
Political Risk and Cost of Capital
Once a MN company has assessed the political risk
associated with a particular country, it can then adjust
its project cost of capital to take into account this
assessment.
Project (country) cost of capital may be higher than the
firms purely domestic cost of capital.
Depends upon the non-domestic environment in which
the firm engages.
Globalizing the Firms Capital Structure
As global firms take on a global capital structure, the
next issue is to what extent does this global capital
structure affect the global firms cost of capital?
Can it source in overseas financial markets where
financing costs are lower than back home?
This will lower the firms overall cost of capital!
Estimating Cost of Capital
As noted, 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 (using debt) firm, the financing costs can
be represented by the weighted average cost of capital.
Weighted Average Cost of Capital
K = (1 )Kl + (1 t)i
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
t = marginal corporate income tax rate
The Firms Investment Decision and the Cost of
Capital
A firm that can reduce its
cost of capital (k) will
increase the profitable
capital expenditures that
the firm can take on (and Klocal
can increase the wealth of
the shareholders).
Internationalizing the firm Kglobal
may be one such policy.
IRR
Markets
Capital Structure
Investment ($)
Ilocal Iglobal
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):

Ri = Rf + bi(RM Rf)

Cov(Ri ,RM)
where bi=
Var(RM)
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.
Ri = Rf + bi (RU.S. Rf)
Versus
W
Ri = Rf + bi (RW Rf)
Cost of Capital in Segmented vs. Integrated
Markets
Clearly integration or segmentation of international
financial markets has major implications for
determining the cost of capital.
 Does the Cost of Capital Differ among
Countries?
There do appear to be differences in the cost of capital
in different countries.
In general;
Smaller and less liquid financial markets have higher financing
costs.
Segmented markets carry higher financing costs.

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.
Does the Cost of Capital Differ among Countries?
Implications for MN Firms:
MN firms may be able to lower their overall cost of
capital through a strategy of internationalize the firms
capital structure.
Less Liquid Financial Markets
Definition: An illiquid market is characterized by
small turnover.
Difficulties in raising funds, especially large offerings.
Market distortions associated with raising funds.
Impacts on share prices and interest rates.

A firm that must source its long-term debt and equity in

a highly illiquid domestic securities market will probably
have a relatively higher cost of capital and will also face
limited availability of such capital.
Strategies need to be designed to allow firms to
finance in more liquid markets.
 Small Financial Markets
Relatively small financial markets have difficulty in
meeting the large financing needs of firms.
Thus, financing costs are likely to be higher for firms
financing under such conditions.
Firms need to develop strategies to allow them to finance
in larger international markets.
Segmented Financial Markets
Capital markets become segmented because of such factors
as
excessive regulatory control,
perceived political risk,
anticipated FOREX risk,
lack of transparency,
insider trading and other market imperfections.
Consequence of a segmented market:
the required rate of return on securities will be higher than the required
rate of return on securities of comparable quality traded on other securities
markets; thus, higher cost of capital for these markets!
Firms in segmented capital markets must devise a
strategy to escape dependence on that market for their
long-term debt and equity needs.
Firm Specific Influences on Financing
Options
Some firms because of their relatively small size,
short history, and/or appeal may not be able to
escape their domestic capital markets.
If constrained to small, less liquid, and/or segmented
domestic capital markets this will result in higher
financing costs for these firms. may be constrained to
their domestic capital market.
These firms will be at a competitive disadvantage to others.
These firms must design strategies to overcome their
firm specific barriers to international markets.
Strategies for Overcoming Small, Less Liquid
and Segmented Markets
Firms financing in small, less liquid, and/or
segmented capital markets will do so at relatively
higher costs.
Higher interest rates.
Lower prices for equities.
What strategies can these firms use to escape these
markets?
Cross list equity on the worlds major stock exchanges
(New York and London).
Cross-border Listings of Stocks
Cross-border listings of stocks benefit a company in the
following ways.
1. The company can expand its potential investor base, which will
lead to a higher stock price and lower cost of capital.
2. Cross-listing creates a secondary market for the companys shares,
which facilitates raising new capital in foreign markets.
3. Cross-listing can enhance the liquidity of the companys stock.
4. Cross-listing enhances the visibility of the companys name and
its products in foreign marketplaces.
Cross-border Listings of Stocks
Cross-border listings of stocks do carry costs.
1. It can be costly to meet the disclosure and listing
requirements imposed by the foreign exchange and
regulatory authorities.
2. Once a companys stock is traded in overseas markets,
there can be volatility spillover from these markets.
3. Once a companys stock is make available to
foreigners, they might acquire a controlling interest
and challenge the domestic control of the company.
Cross Listing as a Strategy
What can a firm hope to achieve through cross
listing?
Cross listing on major exchange will force the
firm as it complies with listing requirements to
increase its level of financial disclosure.
Firm becomes more transparent.
Management is more likely to manage in the best
interest of shareholders.
Corporate governance improves!
Impact of Cross Listing on Cost of Capital
Cross listing which results in more stringent
disclosure and better corporate governance, can result
in lower financing costs.
Share prices may rise as a result of cross listing in New
York or London; i.e., positive revaluation of share price.
Andrew Karolyi (1996) study: cross listing resulted in a
reduction in the cost of equity capital of 114 basis points on
average.
Debt cost will probably also be favorably affected!
On average, cross-border listings of stocks appears
to be a profitable decision. The benefits outweigh
the costs.
Evidence on Cost of Capital Differences:
After Tax Cost of Debt
Evidence on Cost of Capital Differences:
Cost of Equity
Evidence on Cost of Capital Differences: After Tax
Cost of Capital
Capital Asset Pricing Under Cross-Listings
Recall the definition of beta: Cov(Ri ,RM)
bi =
Var(RM)
We can recalibrate the CAPM formula

Ri = Rf + bi(RM Rf)
As
Cov(Ri ,RM)
Ri = Rf + (RM Rf)
Var(RM)

We can develop a measure of aggregate risk aversion, AM

 (RM Rf)
AMM =
Var(RM)
We can restate the CAPM using AM

Ri = Rf + AMM Cov(Ri ,RM)

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.
Ri = Rf + AWW Cov(Ri ,RW)
Capital Asset Pricing Under Cross-Listings
Ri = Rf + AWW Cov(Ri ,RW)
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.
Does Cost of Financing Differ Among
Financing Options?
Answer: Yes!
Eurobond financing is typically lower than comparable
domestic borrowing.
Eurobonds are bearer bonds!
Eurobonds have less regulation.
Lowers the cost of issuing.

Implications for Global Firms

Global firms may be able to lower their overall cost of
capital through a strategy of utilizing lower cost
financing options (such as the euromarkets).
Do Firms in Different Countries have
Different Costs of Capital?
Answer: Historically, yes!
Japan and German firms typically lower than U.S. and
U.K. firms (1970s, 1980s and early 1990s)
Why?
Firms utilizing different capital structures (debt/equity
ratios)
Japans advantage: Low cost, long term debt.
Germanys advantage: Low cost, short term debt (bank
loans).
However, these costs differences tend to be
narrowing!
Probably due to the globalization of U.S. and U.K. firms.
Evidence on Cost of Capital Differences:
Debt to Equity Ratios
Cost of Capital for Global
versus Domestic Firms
Question facing Global Firms:
Is the weighted average cost of capital for a global
firm higher or lower than for its domestic
counterpart?
The answer is not simple; it is a function of:
The relative cost of equity
The after-tax cost of debt
The debt capital ratios
Review of 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 (cost of
capital).
3. Find NPV by discounting the cash flows at the
appropriate discount rate (cost of capital).
4.Compare the value of competing cash flow
streams at the same point in time.
International Capital Budgeting
Capital budgeting 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 NPV using the U.S. cost of capital as
a benchmark.
Adjust U.S. cost of capital to account for political
risk issues.
 International Capital Budgeting
Example
600 200 500 300

0 1 2 3
interest rate =
3%
Is this a good
$.55265 investment from
S0($/) =
$ interest rate =
6%
the perspective of
Cost of capital = the U.S.
15% shareholders?
International Capital Budgeting:
Example
$331.60

600 200 500 300

0 1 year 2 years 3 years

CF0 = (600) S0($/) = (600) $.55265 = $331.60

International Capital Budgeting:
Example
$331.60 $113.70

600 200 500 300

0 1 year 2 years 3 years

CF1 = (200)E[ S1($/)] =
E[ S1($/)] can be found by using the interest rate
differential (IFE):
E[S(1)] = 1.06 S0($/) = 1.06 $.55265 = $.5687/
1.03 1.03
so CF1 = (200)($.5687/) = $113.7
International Capital Budgeting:
Example
$331.60 $113.70 $292.60

600 200 500 300

0 1 year 2 years 3 years

Similarly,

CF2 = 1.06 1.06 S0($/) (500) = $292.6

1.03 1.03
International Capital Budgeting:
Example
$331.60 $113.70 $292.60 $180.70

600 200 500 300

0 1 year 2 years 3 years

(1.06)3
CF3 = 3
S0($/) (300) = $180.7
(1.03)

$113.70 $292.60 $180.70

NPV $336.60 2
3
$107.30
(1.15) (1.15) (1.15)
International Capital Budgeting Issues
Estimating future spot rates for the purpose of
converting foreign currency earnings to U.S. dollar
earnings.
Use parity model (IFE) to estimate future spot rate.
Determining the appropriate cost of capital.
Begin with home country cost of capital
This will take into account the impact of a globalized capital
structure on the firms home country cost of capital.
Adjust home country cost of capital for the foreign
environments political risk.
Analyze the foreign project on this basis!
 Continue with the next power
point