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Global Cost of Capital and Financial Structure

Global Cost of Capital and Financial Structure. International Financial Management. Dr. A. DeMaskey. Learning Objectives. What is a firm’s cost of capital? How is the cost of capital for foreign investments determined?

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Global Cost of Capital and Financial Structure

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  1. Global Cost of Capital and Financial Structure International Financial Management Dr. A. DeMaskey

  2. Learning Objectives • What is a firm’s 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 MNC’s worldwide capital structure?

  3. 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.

  4. 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

  5. Beta Coefficient • Beta is the measure of systematic risk for asset i, which is computed as: Where: ρim = correlation between asset i and the market σi = standard deviation of returns on asset i σm = standard deviation of returns on the market portfolio

  6. 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)

  7. 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 project’s WACC will equal: WACC’ = wd’kd’(1 - T) + we’ke’

  8. 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?

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

  10. The Relevant Base Portfolio • Home Market Portfolio ri = rf + bius (rus – rf) • Global Capital Asset Model ri = rf + big (rg – rf) where:

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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%

  16. 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

  17. 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 firm’s cost of capital

  18. 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

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