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The Cost Of Capital For Foreign Investments

The Cost Of Capital For Foreign Investments. Learning Objectives. To determine the cost of capital for foreign investments and identify those circumstances under which that cost should be higher, lower, or the same as that for comparable domestic projects

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The Cost Of Capital For Foreign Investments

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  1. The Cost Of Capital For Foreign Investments

  2. Learning Objectives • To determine the cost of capital for foreign investments and identify those circumstances under which that cost should be higher, lower, or the same as that for comparable domestic projects • To identify and address the key issues involved in applying the capital asset pricing model to estimate the cost of capital for foreign projects • To illustrate the impact of globalization on the cost of capital • To calculate the effective dollar costs of foreign currency borrowing taking into account interest rates, exchange rate changes, and taxes • To identify the relevant factors and tradeoffs in establishing a company’s worldwide capital structure • To calculate the value of below-market financing opportunities

  3. Key Terms • Capital asset pricing model (CAPM) • Global CAPM • Corporate international diversification • Cost of equity capital • International portfolio diversification • Market risk premium • Project beta • Sovereign risk premium • Systematic (nondiversifiable) risk • Weighted average cost of capital (WACC) • Worldwide capital structure • Zero- coupon bond

  4. Cost of Capital The cost of capital for a given investment is the minimum risk-adjusted return required by shareholders of the firm for undertaking that investment

  5. The Cost of Equity Capital The cost of equity capital for a firm is the minimum rate of return necessary to induce investors to buy or hold the firm’s stock

  6. The Cost of Equity Capital Capital Asset pricing model (CAPM)

  7. The Cost of Equity Capital • ba = beta of asset a, a measure of its non-diversifiable (systematic) risk. Project beta is the beta for the project taken on its own • rm - rf = market risk premium

  8. The Weighted Average Cost Of Capital For Foreign Projects(WACC) ke(1-d) + id(1-t)d where • d = the firm’s debt-to-assets ratio (debt ratio) • id = before-tax cost of debt • ke = cost of equity • t = marginal tax rate of the firm

  9. The Weighted Average Cost Of Capital For Foreign Projects (WACC) WACC is an average representing the expected return on all of a company’s securities. Each source of capital, such as stocks, bonds, and other debt, is weighted in the calculation according to its prominence in the company’s capital structure.

  10. Discount Rates For Foreign Investments 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 betas 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 , if at all, should country risk be incorporated in the cost of capital estimates?

  11. The Cost Of Debt Capital This section shows how to compute the dollar costs of foreign currency debt that would enter into the weighted average cost of capital calculation. These costs take into account the interest rate on the debt, any currency gains or losses, and the effects of taxes

  12. Establishing A Worldwide Capital Structure Foreign subsidiary capital structure • Conform to the capital structure of parent company • Reflect the capitalization norms in each foreign country • Vary to take advantage of opportunities to minimize the MNC’s cost of capital

  13. Establishing A Worldwide Capital Structure Relevant Factors: • Political risk management • Currency risk management • Leverage and foreign tax credits • Leasing and taxes • Cost-minimizing approach to global capital structure • Joint ventures

  14. Valuing Low-Cost Financing Opportunities • Taxes: Zero-coupon bonds – (also called discount bond or deep discount bond) is a bond at a price lower than its face value, with the face value repaid at the time of maturity • Government credit and capital controls • Government subsidies and incentives

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