Business
International Cost of Capital
International Cost of Capital refers to the required rate of return that investors expect to receive on an investment in a foreign market. It takes into account the risks associated with investing in different countries, such as political instability, exchange rate fluctuations, and regulatory differences. Calculating the international cost of capital is essential for businesses making cross-border investments or seeking international financing.
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11 Key excerpts on "International Cost of Capital"
No longer available |Learn moreFinancial Valuation
Applications and Models
- James R. Hitchner(Author)
- 2017(Publication Date)
- Wiley(Publisher)
271 CHAPTER 7 International Cost of Capital C hapter 6 on Cost of Capital (COC)/Rates of Return focuses on COC develop- ment primarily for companies operating in the United States. This chapter pro- vides insight on how to develop a cost of capital that reflects the risk of investing and operating in foreign countries. The discussion is primarily from the perspective of a U.S. investor, but the observations can also be applied to non-U.S. investors analyz- ing opportunities in other countries. BACKGROUND The scope of business valuation often involves valuing a business that is not just a domestic (United States) company but an entity that is located in a foreign country or a business that has a variety of offshore operations, which we refer to as a multi- national company (MNC). Valuations involving offshore markets can be interesting and insightful. They can provide fascinating and varied experiences—such as valu- ing a technology company in Singapore, a chemical plant in Saudi Arabia, a textile manufacturer in China, or an auto parts maquiladora in Mexico—along with the related challenges of how to measure and justify a discount rate for each of these businesses. 1 Before discussing specific models, data gathering, due diligence, and special topics, it’s important to mention a key point that is the foundation of valuation. Ultimately, valuation calculations rely simply on a numerator and a denominator. The numerator in an income approach is the cash flows. The cash flows are typically after-tax, debt-free net cash flows for valuation of a business enterprise or after-tax equity (levered or burdened by debt service) net cash flow for the direct value of an equity position. The numerator in a market approach may be revenues, EBITDA, or another financial parameter. The denominator in an income approach is the capi- talization rate based on the COC less growth rate (factoring in growth and risk).
eBook - PDFInternational Financial Operations
Arbitrage, Hedging, Speculation, Financing and Investment
- I. Moosa(Author)
- 2003(Publication Date)
- Palgrave Macmillan(Publisher)
The lower the firm’s cost of capital, the lower is its required rate of return on a given proposed project. Therefore estimating the cost of capital is a step that must be taken before indulging in the capital budgeting exercise, as we shall see in Chapter 12. For a multinational firm, financing can take a much wider range of forms than for a purely domestic firm. Generally speaking, a multinational firm can raise financing from either internal or external sources. Internal sources include retained earnings and funds provided by subsidiaries. External sources include national and international capital markets. Faced with such a lucrative menu, the multinational firm’s choice depends on several factors, including the following: (i) the need to maintain or strengthen the extent of control over subsidiaries; (ii) the need to receive regular cash inflow from subsidiaries; (iii) the purpose for which financing is needed; (iv) other aspects of the overall business strategy, such as the objective of minimising global tax liabilities; (v) expectations concerning the future path of exchange and interest rates; and (vi) the desire to minimise exposure to various types of risk, such as foreign exchange risk and country risk. The weighted average cost of capital A firm’s weighted average cost of capital, k, is calculated as a weighted average of the cost of debt capital, k d , and equity capital, k e , with the weights deter- mined by the proportions of debt and equity in the capital structure. Thus, if the capital of a firm consists of D debt and E equity, then the cost of capital is given by k D D E k D D E k = + æ è ç ö ø ÷ - + + æ è ç ö ø ÷ d e ( ) 1 t (10.7) where t is the tax rate. The first term, which reflects the weighted cost of debt, [D/(D + E)]k d , is multiplied by the term (1 - t ), which is less than unity. This is because debt financing involves tax saving, given that interest expenses are tax deductible.
eBook - PDFGlobal Corporate Finance
Text and Cases
- Suk H. Kim, Seung H. Kim(Authors)
- 2009(Publication Date)
- Wiley-Blackwell(Publisher)
We seek the optimum or target capital structure that yields the lowest cost of capital. In a second analysis, we attempt to deter-mine the size of the capital budget in relation to the levels of the MCC, so that the optimum capital budget can be determined. The optimum capital budget is defined as the amount of investment that maximizes the value of the company. It is obtained at the intersection between the internal rate of return (IRR) and the MCC; at this point total profit is maximized. A variety of factors affect a company’s cost of capital: its size, access to capital markets, diver-sification, tax concessions, exchange rate risk, and political risk. The first four factors favor the MNC, whereas the last two factors appear to favor the purely domestic company. For a number 482 THE COST OF CAPITAL FOR FOREIGN PROJECTS WACC (%) Weighted average cost of capital Optimal or target debt range Debt ratio (%) 30 0 40 50 Figure 19.2 Debt ratio and the cost of capital of reasons, as shown in figure 19.3, MNCs usually enjoy a lower cost of capital than purely domestic companies. First, MNCs may borrow money at lower rates of interest because they are bigger. Second, they may raise funds in a number of capital markets such as the Euromarkets, local capital markets, and foreign capital markets. Third, their overall cost of capital may be lower than that of purely domestic companies, because they are more diversified. Fourth, they may lower their overall taxes, because they can use tax-haven countries, tax-saving holding compa-nies, and transfer pricing. It seems reasonable to assume that investments outside the United States are, for a US company, riskier than investment in US assets. However, this is not necessarily true, because returns on foreign investments are not perfectly positively correlated with returns on US invest-ments. In other words, MNCs may be less risky than companies that operate strictly within the boundaries of any one country.
eBook - PDF- Shannon P. Pratt, Roger J. Grabowski(Authors)
- 2008(Publication Date)
- Wiley(Publisher)
Alternatively, you can obtain the cost of insurance from organizations providing political risk insurance; for example, the Overseas Private Investment Corporation, the Multilateral Investment Guarantee Agency, or the commercial insurance broker AON sell insurance to insure for risks of currency transfer, expropriation/contract infringement, and war and civil disturbance. Their premiums often are stated as a percent of invested capital or project value (equivalent to adding onto the discount rate). An example of the cost might be in the range of 2% of capital invested for risks in local countries with average credit ratings of approximately Ba2. EXPANDED COST OF CAPITAL FORMULA If we expand the models to also reflect the size effect and specific risk, we can expand the cost of equity capital formula to add these two factors. For example, if we expand Formula 18.3, we get: (Formula 18.9) k local ¼ R f ;u:s: þ ½B u:s: RP u:s: ðs local =s u:s: Þ þ RP s þ RP u where: k local ¼ Discount rate for equity capital in local country R f,u.s. ¼ U.S. risk-free rate B u.s. RP u.s ¼ Risk premium appropriate for a U.S. company in similar industry as the sub- ject company in the local country s local ¼ Volatility of local country stock market s u.s. ¼ Volatility of U.S. stock market RP s ¼ Risk premium for small size RP u ¼ Risk premium attributable to the specific company (u stands for unique or un- systematic risk). (See notes accompanying previous formulas.) Note that the only difference between this formula and an international version of the build-up method formula is the addition of the beta coefficient. (See notes accompanying previous formulas.) SHOULD PROJECTED CASH FLOWS AND THE COST OF CAPITAL BE NOMINAL OR REAL? In the models presented, we have developed nominal cost of capital estimates in that they reflect future expectations of inflation. Therefore, expected cash flow forecasts need to match; they need to reflect expected inflation.
eBook - PDF- E. Porras(Author)
- 2010(Publication Date)
- Palgrave Macmillan(Publisher)
6 1 A General Introduction to Risk, Return, and the Cost of Capital The relevance of the cost of capital The cost of capital to a firm is the return 1 investors receive on their investments. Therefore, in this context, an investor is anyone who lends money to a firm or agency in exchange for some ‘profit’. The providing of funds to the firm could be done by purchasing some of the company’s common stock, bonds, 2 or in a number of additional ways we shall comment on later. The higher the profit desired by the investor, the greater the cost to the firm or paying agency. One reason why firms calculate their cost of capital is to determine a mini- mum discount rate 3 to use when evaluating proposed capital expenditure projects. The purpose of capital expenditure analysis is to decide which, if any, of a list of planned projects, the firm should actually undertake. It is then logical that the cost of capital to be estimated and compared with the expected benefits from the proposed projects is equated with the marginal cost of capital the firm raises (the price of acquiring the next dollar, pound, yen or euro ...), not a historical-cost estimate. This is because firms must incorporate the real costs into their calculations when capital is going to be raised, and past histori- cal information is of no use for this purpose. If the marginal cost of capital is too high, the firm might find out none of its list of proposed projects is capable of returning sufficient profit to cover that cost. For example, let us say you want to open a photocopying business. This project is going to be financed exclusively with equity 4 and, considering the return that could be made on equivalent investments, your shareholders want a 35 per cent return. If all you can expect to make with this project is 10 per cent on each dollar invested, you could not afford to repay what your investors demand.
eBook - PDF- Robert Parrino, David S. Kidwell, Thomas Bates(Authors)
- 2016(Publication Date)
- Wiley(Publisher)
Researchers have found that all the above factors do affect the cost of capital and hence the valuation of assets in such countries. Unfortunately, the standard models are often inadequate in dealing with these conditions. Adjusting the future cash flows or the discount rate helps to address this problem. However, there are still issues that can greatly complicate the analysis. Some of the issues that affect the ability to obtain good estimates are as follows: Variation in the cost of capital between local firms and global firms . In emerging markets, global firms in countries that derive a large part of their revenues outside their home market have lower cost of capital than firms in the same industry that operate only domestically. Therefore, for a foreign firm investing in the country, it is not clear whether the local or global cost of capital is appropriate. The cost of capital is context sensitive . Because of emerging market macroeconomic volatility and a tendency for emerging economies to experience periodic crises, estimates of the cost of capital can vary significantly, depending on the business cycle and crises. It is therefore unclear whether it is appropriate to use a crisis cost of capital or normal conditions or a blend of these in evaluating capital projects. For instance, Moody’s Investor Services has undertaken a comparison of default rates that indicates that the average emerging market 10-year cumulative default rate is about 20 per cent, but this masks the fact that for countries that suffer a crisis, the 10-year cumulative rate is much higher at just over 28 per cent. This represents a country risk spread of about 2.35 per cent versus 3.74 per cent in the two cases. Translated into a country risk spread using a 1.5 equity volatility to debt volatility factor gives a country risk premium of either 3.52 per cent or 5.21 per cent, a difference of 1.69 per cent.
eBook - PDF- Alan C. Shapiro, Paul Hanouna(Authors)
- 2019(Publication Date)
- Wiley(Publisher)
6 Campbell R. Harvey, “The World Price of Covariance Risk,” Journal of Finance, 1991. 7 See, for example, K.C. Chan, G. Andrew Karolyi, and René M. Stulz, “Global Financial Markets and the Risk Premium on U.S. Equity,” Journal of Financial Economics, 1992; and Giorgio DeSantis and Bruno Gerard, “International Asset Pricing and Portfolio Diversification with Time-Varying Risk,” Journal of Finance, 1997. 438 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS A Recommendation. Despite the evidence in favor of the global CAPM, a pragmatic recommendation is for U.S. MNCs to measure the betas of international operations against the U.S. market portfolio. This recommendation is based on the following two reasons: 1. It ensures comparability of foreign with domestic investments, which are evaluated using betas that are calculated relative to a U.S. market index. 2. The relatively minor amount of international diversification attempted (as yet) by American investors suggests that the relevant portfolio from their standpoint is the U.S. market portfolio. This reasoning suggests that the required return on a foreign project may well be lower, and is unlikely to be higher, than the required return on a comparable domestic project. Thus, applying the same discount rate to an overseas project as to a similar domestic project probably will yield a conservative estimate of the relative systematic riskiness of the project. Using the domestic cost of capital to evaluate overseas investments also is likely to understate the benefits that stem from the ability of foreign activities to reduce the firm’s total risk. As we saw in Chapter 1, reducing total risk can increase a firm’s cash flows. By confining itself to its domestic market, a firm will be sensitive to periodic downturns associated with the domestic business cycle and other industry-specific factors. By operating in a number of countries, the MNC can trade off negative swings in some countries against positive ones in others.
eBook - PDF- Alan C. Shapiro, Peter Moles(Authors)
- 2014(Publication Date)
- Wiley(Publisher)
9 Campbell R. Harvey, “The World Price of Covariance Risk”, Journal of Finance (March 1991): 111–157. 10 See, for example, K.C. Chan, G. Andrew Karolyi, and René M. Stulz, “Global Financial Markets and the Risk Premium on U.S. Equity”, Journal of Financial Economics (October 1992): 137–167; and Giorgio DeSantis and Bruno Gerard, “International Asset Pricing and Portfolio Diversification with Time-Varying Risk”, Journal of Finance 52 (1997): 1881–1913. 470 THE International Cost of Capital A Recommendation. Despite the evidence in favor of the global CAPM, a pragmatic recommen- dation is for multinational firms to measure the betas of international operations against the domestic market portfolio. This recommendation is based on the following two reasons: 1. It ensures comparability of foreign with domestic investments, which are evaluated using betas that are calculated relative to a domestic market index. 2. The relatively minor amount of international diversification attempted (as yet) by investors suggests that the relevant portfolio from their standpoint is the domestic market portfolio. This reasoning suggests that the required return on a foreign project may well be lower, and is unlikely to be higher, than the required return on a comparable domestic project. Thus, applying the same discount rate to an overseas project as to a similar domestic project probably will yield a conservative estimate of the relative systematic riskiness of the project. Using the domestic cost of capital to evaluate overseas investments also is likely to understate the benefits that stem from the ability of foreign activities to reduce the firm’s total risk. As we saw in Chapter 1, reducing total risk can increase a firm’s cash flows. By confining itself to its domestic market, a firm will be sensitive to periodic downturns associated with the domestic busi- ness cycle and other industry-specific factors.
eBook - PDFThe Cost of Capital
Theory and Estimation
- Cleveland S. Patterson(Author)
- 1995(Publication Date)
- Praeger(Publisher)
Among the more important of these are the appropriate treatment of transfer prices and the payment of royalties, management fees and dividends to the parent, and foreign tax payments and associated domestic credits. Also important are "sovereign risks," such as the risk of expropriation or restrictions on funds transfer, and the effects of fluctuations in foreign exchange rates. Similarly, the determination of appropriate discount rates is complicated by the fact that nominal costs of capital vary widely across different countries because of differences in expected inflation rates, and even real risk-adjusted rates may vary significantly if capital markets are segmented. Capital costs may also be affected by such factors as tax differentials and the existence of subsi- dies or penalties associated with foreign financing. Because the focus of the book is on the cost of capital, rather than on the identification and forecasting of future expected cash flows, the latter issue is not discussed in detail. To make this distinction, however, it is necessary to clarify the manner in which the potential impact of such factors as sovereign risks and foreign exchange rate fluctuations should be partitioned between ad- justments to E[C t ] and adjustments to discount rates. The perspective taken, as in the domestic context, is that of the shareholders of the parent firm. The incremental operating cash flows in question are there- fore expected levels in each year that are remittable to the parent (whether actually remitted or not), and operating taxes are net to the parent after all payments and credits. Similarly, it is assumed that risks are assessed with refer- ence to portfolios held by investors in the country where the parent oganization is located. Within this framework, the partitioning and assessment of risks can conceptually be done by addressing three questions: i. What is the direct effect on E[C t ]of the risk? ii.
eBook - PDFForeign Direct Investment
Theory, Evidence and Practice
- I. Moosa(Author)
- 2002(Publication Date)
- Palgrave Macmillan(Publisher)
Assume that the firm services all of its debt from a domestic currency base. In this framework, fluctuations in the exchange rate will affect the cost of debt capital, and therefore the overall cost of capital. The pre-tax cost of debt capital is: k d D D D D D D k d (7:39) The overall cost of capital is: k (1 ) D D D E (1 k d )(1 _ S) 1 D D D E k d E D D E k e (7:40) where it is assumed that D is measured in domestic currency terms. Notice that: @k @ _ S D D D E 1 k d > 0 (7:41) which implies that an appreciation of the foreign currency leads to a rise in the overall cost of capital. CAPM AND THE COST OF CAPITAL The capital asset pricing model (CAPM) can be used to show why the cost of capital of an MNC differs from that of a purely domestic firm. 206 Foreign Direct Investment The CAPM is used to determine the required rate of return on a stock, k j , as follows: k j i (k m i) (7:42) where i is the risk-free interest rate, k m is the market rate of return where the market is represented by a stock price index, and is the beta of the stock, measuring the degree of correlation between the stock price and the market. The market is represented by a stock price index, which could be a national stock price index if the markets are segmented, and a world index if markets are integrated. 5 Thus, three factors determine k j : the risk-free interest rate, the market rate of return, and the beta of the stock. An MNC cannot control the risk- free rate or the rate of return on the market, but it can influence its beta. By reducing its beta, an MNC can reduce its cost of capital. For a well-diversified MNC with cash flows generated by several projects, each project contains two types of risk: (i) unsystematic risk that is unique to the project; and (ii) systematic risk. CAPM suggests that unsystematic risk can be ignored, since it can be diversified away.
eBook - PDF- Jack Broyles(Author)
- 2003(Publication Date)
- Wiley(Publisher)
International Investment 22 Appraising International Capital Projects 41 5 Appraising International Capital Projects 1 An international project is an investment in real assets involving cash flows in more than one currency. 2 The international aspect introduces at least two important problems for us to consider. The first is how to analyze a project in the context of changing foreign exchange rates. The second is how to analyze effects of being subject simultaneously to both domestic and foreign tax jurisdictions. We shall consider two related methods of valuing the multicurrency cash flows for an international capital project. Comparison of the methods in their simplest form reveals how we can obtain the net present value (NPV) of after-tax multicurrency cash flows without introducing distortion from biased foreign exchange rate forecasts. This enables us to make a financial assessment on the basis purely of the commercial and fiscal merits of the project. In our initial analysis, we assume a foreign subsidiary operates the project and remits all net cash flows to the parent company. Subse- quently, we discuss situations in which altering this remittance assumption can affect a foreign project’s NPV. TOPICS We cover the following topics: appraisal of international projects; differential rates of inflation and foreign currency cash flows; differential rates of inflation and required rates of return; Valuation Method 1; differential rates of inflation and expected future exchange rates; Valuation Method 2: before tax and after tax; unremitted funds; international required rates of return. 1 Adapted by permission of J. R. Franks, J. E. Broyles, and W. T. Carleton (1985) Corporate Finance, Concepts and Applications (Boston: Kent). 2 So, except for taxation, we treat projects spanning different countries in the euro zone as domestic projects.
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