1


Weighted average cost of capital?

How to find international cost of equity?

Market liquidity/segmentation & cost of capital?

MNE vs. domestic counterpart WACC?
2

k
WACC
 k e
E
V
 k d
( 1
 t)
D
V k
WACC
= weighted average cost of capital, WACC k k d e
= risk adjusted cost of equity
= before-tax cost of debt t = tax rate
E = market value of equity
D = market value of debt
V = market value of firm (D+E)
3

•
World CAPM (W. Sharpe).
•
Segmented/Integrated CAPM (G. Bekaert & C. Harvey).
•
Goldman Sachs - integrated .
•
A.Damodaran’s method.
4


Intuition: required rate of return depends on how investment contributes to volatility of well diversified portfolio.

Expected return (in US$) on investment
= risk-free rate + b x world risk premium.

Beta ( b
) measured relative to
“world” portfolio
.

What is beta?
b 
 jm
  j
 m
•
Shows degree of “co-movement”

Model assumption: perfect market integration.
•
OK for developed markets ( if allow risk to vary through time ).
•
Gives unreliable results in smaller/illiquid developed markets.
•
Fails in emerging markets.
5

Returns & Beta, 1990 - 2002
-0.5
0.5
0.4
0.3
0.2
0.1
0
-0.1
0 0.5
1 1.5
Beta
Wrong risk / return relation !!
2
Source: Cam Harvey’s web site @ http://www.fuqua.duke.edu
2.5
6
3


CAPM assumes perfect integration. Markets oftentimes aren’t!

STEPS

Estimate world beta & expected return = world CC
= risk-free + b
W x world risk premium.

Estimate local beta & expected return = local CC
= local risk-free + b
L x local risk premium.

Put two in common currency terms.

Add up two components:
CC = w * [world CC] + (1-w) * [local CC]

Weight w , determined by proxies for degree of integration: size of international trade & [equity market capitalization/GDP]

Downside: appropriate for countries w/ equity markets.
7

*

CAPM gives low expected return, so add sovereign yield spread.

Idea: Default risk premium correlated w/ equity risk premium.

Sovereign yield spread: yield on US$ bond a country offers vs.
US T-bond of same maturity.

Spread reflects “country risk”

STEPS

Estimate market beta on S&P 500.

Get beta times historical US equity premium.

Add sovereign yield spread plus risk free to get equity risk premium.

Useful if you have sovereign yield spread.

Model used by McKinsey, Salomon & others.
*J.Mariscal & R. Lee, “Valuation of Mexican Stocks: An extension of the capital asset pricing model to emerging markets”, Goldman Sachs, 1993.
8

Source: Ibbotson Associates
9

Source: Ibbotson Associates 10


Cost of equity: calculate using Capital Asset Pricing Model
(CAPM) k e
 k rf
 b
( k m
 k rf
)
Where k e k rf
= expected rate of return on equity
= risk free rate on bonds k m
= expected rate of return on market
β = coefficient of firm’s systematic risk

Cost of debt: analyze proportions of various debt & their associated interest rates & calculate before- & after-tax weighted average cost of debt.
11


A company headquartered in US

Use US as base for market & equity risk calculation k
WACC
= weighted average cost of capital k k d e
= Cost of equity is 17%
= Before-tax cost of debt is 8% t = tax rate of 35%
E/V = equity-to-value ratio 60%
D/V = debt-to-value ratio 40% k
WACC k
WACC

17 %

0 .
60

8 %

( 1

0 .
35 )

0 .
40

12 .
28 %
12


Market liquidity: degree to which firm can issue new securities without depressing existing market prices.

Market illiquidity & segmentation influence marginal cost of capital

Market Segmentation: claims w/ same expected return & risk class have different rates of return even after accounting for forex & political risks.

Caused by:
•
Asymmetric information
•
High transaction costs
•
Corporate governance practices
•
Regulatory barriers
13

20%
15%
13%
10%
*
Marginal cost of capital &
Marginal rate of return
(%)
MNE from illiquid market
MNE from illiquid & segmented market
Domestic k
D
MCC
D k
F
MCC
F
MCC
U k
U
MRR
10
* Marginal Cost of Capital
20 30 40 50 60
Budget
($million)
14


Empirical studies have found that:
•
MNE has lower debt/equity ratio
•
MNE has higher systematic risk!
b 
 jm
– Hidden Actions of Managers (Agency Costs)
–
Asymmetric (Hidden) Information
  j
 m
–
Political Risk
– Forex Risk
•
So: MNE WACC could be > WACC domestic.
•
But: MNE tend to be mature firms that follow pecking order
– i.e. they use
– internal cash
– Debt
– & rarely new equity
–
Why? Equity is information sensitive!!!
15

Theory: MNE should have low cost & abundant capital.
Marginal cost of capital (%)
MCC
DC
Small
Set of Projects
Large
Set of Projects
20%
15%
10%
5%
100 140
MRR
DC
300 350
MCC
MNE
400
MRR
MNE
Budget
($m)
16

MNE
WACC
>?< Domestic
WACC k
WACC
= k e
[ Equity
Value
Debt ]
+ k d
( 1 – tax )
[
Value
]
MNE: lower debt/capital ratio => higher cost capital.
MNE: lower cost of debt => lower cost capital.
• Required cost of equity higher for MNE ( Political risk , forex risk , high agency costs).
•=> At high levels of capital budget, MNE has lower cost of capital.
17


Weighted average cost of capital?

How to find international cost of equity?

Market liquidity/segmentation & cost of capital?

MNE vs. domestic WACC?
18