INTERNATIONAL EQUITY
MARKETS
1. Differences and Instruments
General Overview and Differences
• Differences
- Macrostructure
- Liquidity
- Taxes
- Indexes
- Microstructure
- Organization
- Trading Procedures
Liquidity
Liquidity
“Ability to buy or sell significant quantities of a security quickly,
anonymously, and with minimal or no price impact.”
=> Most important attribute for an asset.
• Usual measures are:
1. Capitalization/GDP
2. Transaction size (market turnover)
3. Degree of concentration
4. Bid-ask spread
5. Number of non-trading days
6. Number of zero-return days
1. Capitalization/GDP
Fact: U.S. stock market is very large compared to the U.S. economy. See
figures in Dec. 2014 USD.
Market
U.S.
China
Japan
U.K.
India
Brazil
Market Cap (MC)
26,240 B
6,005 B
4,378 B
6,370 B
3,324 B
844 B
GDP (nominal)
17,416 B
10,355 B
4,770 B
2,847 B
2,047 B
2,244 B
MC/GDP
151%
57%
92%
224%
162%
37%
But, this number may not be a good indicator: for South Africa, in 2009,
the MC/GDP was over 170%.
Also, this figure changes a lot. The MC/GDP for Brazil in 2009 was
close to 50% and in 2007 was close to 100%.
• Some analysts (Warren Buffet included) see the MC/GDP measure as
a valuation metric, useful to identify what markets are under-/overvalued. The higher the ratio, the more overvalued the market. For
example, Swiss market => overvalued!
2. Transaction volume
• Define turnover (T) as the total value of share trading. Not surprisingly,
New York and Tokyo have the largest turnover (T) in USD (Dec. 2007).
NYSE
2,158.0 B
NASDAQ
1,187.3 B
London SE
441.4 B
Tokyo SE
440.5 B
Euronext SE
340.0 B
Shangai SE
272.4 B
• Turnover as a percent of market capitalization (T/MC) varies over time.
Example: From 1991 to 1995 annual turnover ranged:
U.S.:
55% - 74%
France:
33% - 140%
=> not very precise, if different years were observed.
3. Degree of concentration found in the major markets
• Composition: many small firms vs. concentrated in a few large firms.
Institutional investors dislike small firms for fear of poor liquidity.
A concentrated market provides fewer opportunities for risk
diversification and active portfolio strategies.
Example: Market share of the 10 largest companies.
U.S.
11.9%
Japan
20.2%
U.K.
23.2%
Germany
39.2%
Switzerland 67.0%
Netherlands 74.3%
4. The bid-ask spread
Market maker buys shares (at the bid quote) and expects to sell those
shares in the future (at the ask quote).
The longer it takes to receive a buy order  The higher the required
compensation  Higher compensation
=> Higher bid-ask spread.
An average bid-ask spread is a useful market liquidity indicator.
Example: The average bid-ask spread in the U.S. is 0.6%, while in
Thailand the average bid-ask spread is 5.14%.
Problem with this measure: Not easy to obtain –definitely, not in the
WSJ.
5. Non-trading days
Market may be seem liquid on average, but there is no volume during
some days. The number of non-trading days gives us an idea of liquidity.
6. Zero-return Days
Two things behind a no change in the price –i.e., zero return:
- No information
- No trading (stale prices)
=> proxy for non-trading days
It is an easy measure to gather, just from stock prices.
Conclusion: Take a look at several liquidity indicators.
Example: Liquidity -- The Case of Emerging Markets
Taxes
 Taxes on Investments
1. Capital gains,
2. Income (dividends, etc.),
3. Transactions.
• Key question for international investors:
Q: Do they tax foreigners? If so, what are the withholding taxes?
 Two Tax principles
- Residence: Residents are taxed on their worldwide income.
- Source: All income earned inside the country is taxable in this
country.
When entire income is earned in the country of residence, both principles
agree. Otherwise, the two principles have different (negative)
implications.
Example:
Situation: A U.S. consultant works 3 months a year in Greece.
Residence principle: she pays taxes on her Greek income in the U.S.
Source principle: she pays taxes on her Greek income in Greece.
 Greek income can be taxed twice. ¶
• Foreign investments may be taxed in two locations:
1. the investor's country,
2. the investment's country
Convention: make sure that taxes are paid in at least one country.
 that is why withholding taxes are levied on dividend payments.
 Tax Neutrality
Tax neutrality: no tax penalties associated with international business.
Two approaches:
(1) Capital import neutrality
(2) Capital export neutrality.
(1) Capital Import Neutrality
- No penalty or advantage attached to the fact that capital is foreignowned
- Foreign capital competes on an equal basis with domestic capital.
- Local tax authorities exempt foreign-source income from local taxes.
=> For a U.S. MNF: Exclusion of foreign branch profits from U.S.
taxable income (exclusion method).
(2) Capital Export Neutrality
- No tax incentive for firms to export capital to a low tax foreign
country.
- Overall tax is the same whether the capital remains in the country or
not.
=> Local authorities "gross up" the after-tax income with all foreign
taxes; then apply the home-country tax rules to that income, and give
credit for foreign taxes paid.
=> For a U.S. MNF: Inclusion of "pre-tax" foreign branch profits in U.S.
taxable income. A tax credit is given for foreign paid taxes (credit
method).
Example: Bertoni Bank, a U.S. bank, has a branch in Hong Kong.
Hong Kong branch income: USD 100.
U.S. tax rate: 35%
Hong Kong tax rate: 17%
Double
Taxation
• Hong Kong
Branch profit
(17% tax) (i)
Net profit
Exclusion
Method
100
17
83
Credit
Method
100
17
83
100
17
83
• U.S.
Net Hong Kong profit
Gross up
Taxable income
(35% tax)
Tax credit
Net Tax due (ii)
83
0
83
29.05
0
29.05
83
0
0
0
0
0
83
17
100
35
(17)
18
Total taxes (i)+(ii)
46.05
17
35
Organization
Three market structure types:
○ Public exchange
○ Private exchange
○ Banker exchange
 The private exchange
Origin: XVII and XVIII century's European commodity markets.
- Private institution with some government supervision.
- Brokers are created by independent members.
- Brokers compete among themselves or enjoy monopoly.
Private exchanges may compete within the same country (U.S., Japan,
China, India).
Commissions: negotiated or imposed by exchange or local law.
Example: U.S., U.K., Canada, Japan, Mexico, Argentina.
 The public exchange
Origin: legislative work of Napoleon I.
- Public institution.
- Brokers are appointed by the government.
- Brokers enjoy a monopoly over all transactions.
Brokerage firms are private.
New brokers are proposed to the state by the broker's association.
Commissions: fixed by law.
Examples: Belgium, Italy, Greece, and some Latin American countries.
 The bankers exchange
Origin: German tradition.
- May be either private or semipublic organizations.
- Brokers are banks.
- Members must deal through the exchange.
In some countries, banks are the major securities traders.
In Germany the Banking Act grants a brokerage monopoly to banks.
Examples: German sphere of
Scandinavia and the Netherlands.
influence:
Austria,
Switzerland,
 Recent Trends
1) Deregulation: The private stock exchange is the norm.
Many exchanges have become business organizations, listed in their own
exchanges.
Example: Paris Bourse, Deutsche Börse, NYSE.
2) Consolidation: Competition has created consolidation:
- OMX: OM & Stockholm Exchange (OMX) (1998); Helsinki (HEX)
(2003); Copenhagen SE (KFX) (2005); Oslo SE (2006); Iceland SE
(2006); Armenian (Armex) (2007)
- NASDAQ buys PHLX and OMX (2007, 2008).
- Euronext: Paris Bourse, Amsterdam (AEX) & Brussels (BXS) (2000);
LIFFE (2002); Lisbon (BVL) (2002).
- NYSE buys Euronext (2006).
- CME buys CBOT (2006)
- Toronto (TSX) & Montreal (MX) (2007)
Differences in Trading Procedures
The most important differences are in the trading procedures.
(1) Cash versus futures markets
(2) Fixed versus continuous quotation
(3) Computerization
(4) Internationalization
(1) Cash versus futures markets
• Cash markets
Stocks are traded on a cash basis (settlement within a couple of days).
For more leveraged investments: margin trading is available.
Margin trading: Investors borrow money from a broker.
 a cash market transaction: a third party steps in.
Note: Margin trading is costly and, sometimes, difficult.
• Futures or forward stock markets
Provide an organized exchange for levered stock investment.
Forward stock markets compete with cash stock markets.
(2) Fixed versus continuous quotation
• Continuous market: transactions take place all day.
- Large market-makers assure liquidity.
- In some markets, the market maker has a monopoly for a given
security, as is the case for the specialist on the NYSE.
- In other markets, the market makers (dealers or jobbers)
compete to provide the best quote.
• Fixed market: transactions take place only at specific times.
- Call or fixing market: a single price applies to all transactions.
- Auction market: an asset is traded only few times per day and its
price is determined through a competitive auction system.
(3) Computerization
• Traditional trading method: floor trading.
- Traders meet on a floor to trade and to execute orders according to a
set of pre-specified rules.
- Floor trading has been greatly influenced by computers: computers
help to make floor trading cheaper, with fewer mistakes and faster.
• New trading method: computerized trading.
- A computer executes orders according to a set of pre-specified rules.
- Computerized trading allows the automated execution of orders
entered by traders in their office.
- Best known system: Computer Assisted Trading System (CATS) TSE.
- CATS eliminated the need for a floor where participants meet.
• Mixed system: NASDAQ.
(4) Internationalization
• Traditional internationalization: International network of offices.
• New trend: Electronically access foreign markets.
 cheaper alternative.
Key to this new trend: Harmonization of electronic trading platforms
Examples:
(i) OMX: OM Stockholm Exchange (SSE), Copenhagen SW (CSE), e
Helsinki SE (HSE), the Iceland SE. (September 2006).
(ii) Euronext: Amsterdam SE, Brussels SE and Paris Bourse (Sep 2000)
(iii) NYSE Euronext: NYSE and Euronext (April 2007)
(iv) NASDAQ OMX: NASDAQ and OMX (February 2008)
International Exchange of the Future: Stock exchanges with their own
automated trading system available worldwide on a 24-hour basis.
Practical Aspects
 Dual Listing
Fact: Some firms are traded on more than a dozen markets.
Implication: Shares should sell at the same price all over the world, once
adjustment for exchange rates and transactions costs are made.
Procedures for admitting foreign stocks to local markets:
Montreal: Listed by simply by meeting the same regulatory requirements
as those in its own jurisdiction.
U.S.: Must satisfy the local exchange and regulatory requirements.
Q: Why do companies double list?
Advantages of double listing:
- easier access to foreign capital.
- diversified ownership reduces the risk of a domestic takeover.
- fragmented markets.
- advertising.
Main disadvantage: Increase volatility.
Example: Situation: Bad political news in Chile.
Foreign investors tend to immediately sell their shares, driving domestic
share prices down in this illiquid stock market.
Chilean investors have a less volatile behavior: they are not as shaken by
domestic news, and have few investment alternatives. ¶
American Depositary Receipts (ADRs)
• Special shares for foreign company: depository receipts.
Many DR programs around the world
U.S.: American depository receipts (ADRs).
U.K: Global DRs (GDRs).
Singapore: Singapore DRs.
Simple process: (1) Foreign shares are deposited with a trust company.
(2) Trust issues DRs.
To avoid unusual share prices, ADRs may represent a combination or a
fraction of several foreign shares.
Example: Petroleo Brasileiro (Petrobras) ADR (PBR)
JP Morgan has a 10 million shares of PBR in deposit.
JP Morgan issues 5 million depository receipts (DR).
Each DR represents 2 Petrobras shares. ¶
• Trading in ADRs
Trading in ADRs avoids delays of trade settlement, problems with
safeguarding, and making currency transactions.
Note: ADRs do not eliminate currency risk or country risk.
Example: BRL depreciates sharply, Petrobras (PBR), USD returns
decrease
 Petrobras ADRs will decline.
• There are more than a 2,700 ADRs available to U.S. investors.
Representing over 80 markets. China has 124 ADR programs.
• ADRs account for more than 15% of the entire U.S. equity market.
ADRs Trading Volume: Exchange Listed ADRs
• Types of ADRs
(1) Listed ADRs (Level II and Level III): companies should meet all the
exchange requirements. In December 1995, there were 316 Listed ADRs:
199 traded on the NYSE, 7 on the American Stock Exchange, and 110 on
the NASDAQ.
(2) Unlisted ADRs: The rest of the ADRs trade on the OTC market (OTC
level I), or privately placed (ADR Rule 144-A, or RADR).
- OTC Level I (pink sheets): Simplest way to access capital in the U.S. A
Level I DR programme does not have to follow U.S. GAAP, nor it has to
make a full disclosure to the SEC.
- RADR: They are privately sold and bought by qualified institutional
buyers (QIBs). QIBs include institutions that manage at least USD 100
million.
Example: KIA Motors, LG Electronics, Samsung are all 144-A ADRs
Examples ADRs in the U.S.:
AUSTRALIA: BHP (NYSE), Foster’s (OTC), Qantas (OTC)
BRAZIL: AES Tiete (OTC) AMBev (NYSE), CVRD (NYSE), VIVO (NYSE)
CHINA: Air China (OTC), Agria Corp. (NYSE), Baidu (NASDAQ)
CHILE: Concha y Toro (NYSE), LAN Airlines (NYSE), Enersis (NYSE)
EGYPT: Orascom Construction (OTC), Orascom Telec (OTC), Suez Cement (OTC)
FINLAND: Neste Oil (OTC), Nokia (NYSE), Stora Enso (OTC), UPM (OTC)
FRANCE: GDF Suez (OTC), France Telecom (NYSE), L’Oreal (OTC)
GERMANY: Allianz (NYSE), BMW (OTC), SAP (NYSE)
GREECE: Alpha Bank (OTC), Hellenic Petrol (NYSE), Hellenistic Telecom (NYSE)
JAPAN: Canon (NYSE), FujiFilm (NASDAQ), Hitachi (NYSE)
KOREA: Korea Electric Power (NYSE), Pohang Steel (NYSE), SK Telecom (NYSE)
MEXICO: Am Movil (NASDAQ), Cemex (NYSE), Femsa (NYSE), Telmex (NYSE)
NETHERLANDS: AKZO Nobel (OTC), ING (NYSE), Crucell (NASDAQ)
RUSSIA: Gazprom (OTC), Lukoil (OTC), Mechel (NYSE), Mosenergo (OTC)
TURKEY: AKBank (OTC), Koc Group (OTC), Petrol Ofisi (OTC), Turkcell (NYSE)
UK: Barclay’s (NYSE), BP (NYSE), British Airways (OTC), Imperial Tobacco (OTC)
Exchange Traded Funds (ETFs)
ETFs are like open-ended mutual funds except that they can be bought
and sold on an exchange like ordinary stocks.
An ETF holds assets: stocks, commodities, bonds, etc. Most ETFs track
an index, such as the S&P 500, the MSCI EAFE or the MSCI Korea.
Relative to mutual funds, ETFs are attractive: low costs and liquidity.
ETFs have had phenomenal growth since inception in 1993.
Financial Analysis and Valuation
• Nothing unique to financial analysis in an international context.
Example: The methods and data required to analyze U.S.-, Mexican, or
Malaysian-type manufacturers are the same. ¶
A research report on a company should include:
(1) Expected return.
(2) Risk sensitivity.
 The
information problem
A firm is typically valued in two steps:
(1) Forecast future earnings (EPS -expected earnings per share)
(2) Assessment of how the stock market will value these forecasts.
(PE -price-earnings ratio)

Information
U.S.: Firms publish their quarterly earnings.
Europe and Far East: Firms only publish their earnings once a year.
• Quality of the disclosed information: Varies from country to country.
There is a market for companies "interpreting" for international investors
the local books of companies:
Many international brokerage houses provide analysts' guides.

Comparative analysis.
Another difficult problem due to:
- Different accounting principles
- Different cultural, institutional and tax differences
Example: Swiss firms stretch the definition of a liability. They tend to
overestimate contingent liabilities when compared to U.S. firms.
Example: German firms create hidden reserves often equal to 100% of
fixed assets. Inventories tend to be understated.

Major differences in international accounting practices:
* Publication of consolidated statements
* Publication of accounts corrected for fiscal distortion
* Inflation accounting
* Currency adjustment
* Treatment of extraordinary expenses
* Existence of "hidden" reserves
* Depreciation rules
* Inventory valuation
• Misunderstanding asset values and reported profits played a major role
in the 1997 Asian crisis.
• The lack of uniform accounting standards is costly.
- International banks and investors charge higher interest rates to
companies that do not adjust follow U.S. or International standards.
- Many firms do not have access to international capital markets because
their national accounting standards distort valuations. Japan ranks below
Spain and South Korea on access to international capital markets.
• Cross-country research by Fan and Wong (2002) and Leuz et al. (2003)
suggests that managers smooth earnings to create opacity to allow
expropriation of assets.
• Opacity and information asymmetry reduce the willingness of investors
to trade and, thus, to increase the liquidity premium.
Lang et al. (2009): In 21 EAFE markets, moving from the 25th to 75th
transparency percentile is associated with a 40% decrease in the median
bid-ask and a 17% reduction in the number of non-trading days.

Convergence
The dream of insurance companies, investors, bankers and regulators.
• Ongoing conversation about converging accounting standards between
the International Accounting Standards Board (IASB), based in London,
and the Financial Accounting Standards Board (FASB), based in the U.S.
The IASB sets and promotes the International Financial Reporting
Standards (IFRS). The FASB caters to the development of U.S. GAAP.
IFRS is a more principles-based approach as opposed to GAAP, which is
more rules-based. IFRS allows more flexibility (judgement, experience).
Most of the world follows IFRS. Seay (2014): the “gold standard.”
Changing accounting standards in the U.S. would be costly. Lin (2013)
estimates that the cost of a full switch to be between 0.5% to 1% of
annual revenues. => USD 40-60 billion for companies in the S&P 500.
Progress towards convergence has been done in many of those areas.
Big remaining issue: Inventory valuation. IFRS does not allow the last-infirst-out (LIFO) method. Reed and Pence (2013), the LIFO method is
used by 36% of companies. LIFO tends to inflate costs and lower taxes.
 Company
Valuation
(1) Discounted Dividend Model (DDM)
• DDM is used to estimate the expected return on an investment:
• The value of an asset is determined by the stream of cash flows it
generates for the investor.
• DDM: Stock price (P) = stream of discounted forecasted dividends.
P = D1/(1+r1) + D2/(1+r2)2 + D3/(1+r3)3 + D4 /(1+r4)4 + ...
• A typical DDM approach is to decompose the future in three phases.
- Near future (next two years), earnings are forecasted individually.
- Second phase (years two to five), a general growth rate for the
company's earnings is estimated.
(revert to industry?)
- Third phase, the growth rate in earnings is supposed to revert to the
average of all firms in the market.
 Dt-forecast's and P are known
 solve for the expected return (r).
Problems:
- Companies have discretion over their dividend payments.
- International comparisons are difficult:
Payout ratios vary considerably. The U.S. has a much lower
payout ratio than the U.K.
- We need a model to calculate r. For example, the CAPM or the 3 Factor
model of Fama-French.
Note: We might also need an accurate forecast of currency movements.
Usually, PPP is used.
Example: Using DDM to calculate the fair value of YPF ADRs
It is December 1995.
We need input values for Dt, rt, and St. t = 1996, 1997, 1998, ....
PYPF-ADR = USD 20.53.
(Market price at NYSE)
St= 1 USD/ARS.
Dt = ?
t = 1996, 1997, 1998, ....
D1996F = ARS .84.
dtF = 9.1% t = 1997, 1998, 1999.
dt is low for international standards  dt should increase in the future:
dtF = 15.7% t = 2000, ...
• rt = ?
t = 1996, 1997, 1998, ....
According to CAPM, we should estimate:
E[rYPF] = rf + E[rm-rf] ßYPF.
Inputs: ßYPF=.91; rf =.085; E[rm]=.18.
E[rYPF] = .085 + (.18-.085) x .91 = .17145.
Example (continuation): YPF ADR Valuation
• St = ?
t = 1996, 1997, 1998, ....
st = -1%
t = 1997, 1998, 1999.
st = -2%
t = 2000, ....
• Valuation Process:
(1) Determine the USD PV of CF from 1996 - 1,999 (year 4), P1-4.
- Effective USD rate of return from 1997 until 1999 is:
[(1.091)x(.099) - 1] = .08009.
- P1-4 = .84/(1.17145) + .84(1.08009)/(1.17145)2 + .84(1.08009)2/(1.17145)3 +
+ .84(1.08009)3/(1.17145)4
= USD 3.5559.
(2) Determine the USD PV of CF from 2000+ (year 5+), P5+.
- The discounted dividends per share in year 4 will be:
USD .84[(1.091)x(.99)]3/(1.17145)4 = USD .56204.
- The effective USD rate of return is [(1.157)x(.098) - 1] = .13386.
- The USD PV of all futures cash flows after year 5 is given by
P5+ = USD .56204 x (1.13386)/[(.17145 - .13386)] = USD 16.9533
Example (continuation): YPF ADR Valuation
(3) Add (1)+(2) -- Present value of a YPF ADR is:
- P = P1-4 + P5+ = USD 3.56 + USD 16.95 = USD 19.50.
The December 1995 price of USD 20.53 indicates that the YPF ADR
was slightly overvalued, given our estimates from the DDM. ¶
(2) Discounting Free Cash Flows
Alternative method to the DCF model: Discount free cash flows. The
usual formula for calculating free cash flow is:
Free CF = EBITDA – Taxes - WC – Capital Expenditures
Once the free CFs are calculated for different years, they are discounted
using the weighted-average cost of capital (WACC), kc:
kc = kWACC = ke (E/V) + (1-t) kd (D/V),
ke: cost of equity (usually, risk-adjusted, based on a model, say CAPM).
kd: before-tax cost of debt (usually, it is an interest rate or bond’s YTM),
t: marginal tax rate,
E: Market value of the company’s equity,
D: Market value of the company’s debt
V: Market value of the firm (=E+D).
• Measuring the cost of capital
WACC:
kc = D/(E+D) kd (1-t) + E/(E+D) ke
• kd
- The cost of debt of a project (kd): the interest a firm has to pay to
borrow from a bank or the bond market to fund a project.
- Easy to determine: A firm calls a bank or an investment bank to find
out the interest rate it has to pay to borrow capital.
Q: How does a bank set the interest rate for a given firm?
A: Base rate (say, a risk free rate like T-bills, rf) + spread (reflecting the
risk of the company/project, which includes CR).
Note: Interest payments are tax deductible
=> After-tax cost of debt = kd*(1-t)
• Measuring the cost of capital
• ke
- The cost of equity of a project (ke): Required (expected) return on
equity a firm has to pay to investors.
- A model is needed to determine required (equilibrium) rates of return
on equity. There are many models. We can use the CAPM or the popular
extended version, with the 3 Fama-French factors.
- Let’s use the CAPM to value the cost of equity:
ke = r = rf +  (rM – rf)
rf: Risk-free rate (in practice, a government rate).
rM: Expected return on a market portfolio (in practice, the long-run return
on a well-diversified market index).
: Systematic Risk of the project/firm = Cov(r,rM)/Var(rM) (in practice, a
coefficient estimated by a regression against risk premium, (rM – rf)).
Notes:
⋄ Dividends are not tax deductible. There is an advantage to using debt!
⋄ Time-consistency with rf . The same maturity should be used for ke and
kd. That is, if you use long-term bonds to calculate kd , you should also
use long-term bonds to calculate r=ke.
⋄ In Chapter 16 we discussed country risk. For practical purposes, many
emerging market governments bonds may not be considered risk-free.
Thus, the government bond rate includes a default spread, which, in
theory, should be subtracted to get rf.
⋄  is estimated by the slope of a regression against a market index.
There are many issues associated with the estimation of : choice of
index, noisy data, adjustment by leverage, mean reversion, etc. We
will not get into these issues..
• Issues:
Q: Real or Nominal? If the CFs are nominal (the usual situation), then ke
should be calculated in nominal terms.
Q: Which rf to use? Local or Foreign? The rf that reflects the risk of the
cash flows.
Q: Which maturity for rf to use? The maturity that reflects the duration of
the cash flows. In practice, the duration of the project is matched to the
maturity of rf (potentially a problem for many emerging markets where
there is no long-term debt market).
Q: Which  to use? The  of the company or the  of the project? The 
should reflect the systematic risk of the project.
Example: GE wants to do an investment in Brazil.
Equity investment: BRR 100M
Debt issue: BRR 150
Value of Brazil investment = D + E = BRR 250
Brazilian Tax Rate = t = 35%
Risk-free rate in Brazil = rf = 7.40%
Return of the Brazilian market (BOVESPA) in the past 10 years: 12%
(rM = 12%)
Cost of project = kc = ?
• Cost of debt (kd)
GE can borrow in Brazil at 60 bps over Brazilian Treasuries (Rf)
kd = rf + spread = .0740 + .60 = .08 (8%)
• Cost of debt (kd)
kd = rf + spread = .0740 + .60 = .08 (8%)
• Cost of equity (ke)
Similar projects in Brazil have a beta of 1.1 (GE-Brazil = 1.1)
ke = rf +  (rm – rf) = .0740 + 1.1 * (.12 - .0740) = 0.1246 (12.46%)
• Cost of Capital –WACC- (ke)
kc = D/(E+D) kd (1-t) + E/(E+D) ke
kc = (.6) x .08 x (.65) + (.4) x 0.1246 = .08104 (8.104%)
Note: This is the discount rate that GE should use to discount the cash
flows of the Brazilian project. That is, GE will require an 8.104% rate of
return on the investment in Brazil. ¶
Remark: Every time the cost of capital increases, the NPV of projects
goes down. Anything that affects kc, it will also affect the profitability
(NPV) of a project.
Application: Argentina defaults in some of its debt. Argentine country
risk increases, kf,Arg goes up and kc,Arg also goes up. Then, NPV projects
in Argentina can become negative NPV projects.
=> MNCs may suddenly abandon Argentine projects.
Notes on estimating the cost of capital:
⋄ Dividends are not tax deductible. There is an advantage to using debt!
⋄ Time-consistency with rf . Same maturity should be used for ke and kd
(long-term bonds to calculate kd, => long-term data to calculate ke.)
⋄ Next chapter discusses country risk (CR). Many emerging market
governments bonds may not be considered risk-free => An adjustment
is needed to get rf: a default spread should be subtracted from YTM to
get rf.
⋄ If company is publicly traded, getting  is simple:  is estimated by a
regression. If the company is not publicly traded, we need to
benchmark : use s of publicly traded similar companies.
⋄ There are many issues associated with the estimation of : choice of
index, noisy data, adjustment by leverage, mean reversion, etc.
Estimating rM:
We use as many years as possible to build the long-run average. Since
averages come with an associated standard error: More data ⟹ lower
S.E. -i.e., more precision. (Potential problem for emerging markets,
where there is limited reliable data)
For a market with limited return history, say Country J, it is sometimes
easier to adjust a rM from a well-established, mature market, say, the
U.S., to estimate that market kM,J. Several ways to do this adjustment:
⋄ Relative Equity Market Approach: The U.S. risk premium is modified
by the volatility of the Country J’s equity market, σJ, relative to the
volatility of the U.S equity market, σUS:
(rM – kf)J = (rM – kf)US * σJ/ σUS
Estimating rM:
A similar adjustment can be done using bonds and the implied country
risk, CR –i.e., bond spread over a safe yield, say U.S. yields.
⋄ Country Bond Approach:
The bond spread is added to the U.S. market risk premium
(rM – rf)J = (rM – rf)US + CRJ (bond spread)
⋄ Mixed Approach:
Since we expect equity spreads to be higher than debt spread, we adjust
the CR upward using volatilities as a measure of risk:
(rM – rf)J = (rM – rf)US + CRJ * σJ/ σJ,bond.
Note: We may have very different numbers from these three approaches.
Estimating rM:
⋄ Judgement calls/adjustments may be needed to pick E[rM – rf]J.
⋄ Following the idea of CR from bond markets, a country equity risk
premium (CER) can be easily derived for Country J:
CERJ = E[rM – rf]J - E[rM – rf]US.
⋄ We construct a market risk premium for Country J based on USD rates.
To change to a local currency premium, we can use IFE combined with
relative PPP to estimate E[ef]. Using the linearized version of both
formulas, we get:
E[rM – rf]J (in local currency) ≈ E[rM – rf]J + (IJ – IUS).
Example: GE’s wants to adjust (rM – rf)Brazil using different methods,
using the U.S. as a benchmark. GE uses the following data:
E[rM – rf]US = 3.65%
σUS = 15.2%
σBrazil = 34.3% (based on past 15 years)
σBrazil,bond = 23.1% (based on past 15 years)
CRBrazil = 2.80%
⋄ Relative Equity Market Approach:
E[rM – rf]Brazil = .0365*.343/.152 = 0.08236
⟹ ke,Brazil = kf +  (kM – kf)Brazil = .0740 + 1.1 * 0.08236 = 0.1646.
⋄ Mixed Approach:
E[rM – rf]Brazil = .0365 + .028 *.343/.231 = 0.07807
⟹ ke,Brazil = rf +  (rM – rf)Brazil = .0740 + 1.1 * 0.07807 = 0.1599.
Example (continuation): Suppose GE decides to use the Relative Equity
Market Approach. Now, GE’s wants to translate the market risk
premium from USD to BRL, using linearized PPP.
Data for average inflation rates:
E[IBrazil] = 7.5%
E[IUS] = 3%
⋄ Relative Equity Market Approach:
E[rM – rf]Brazil = .0365*.343/.152 = 0.08236
E[rm – rf]Brazil (in BRL) ≈ 0.08236 + (0.075-0.03) = 0.12736 . ¶
• Target Debt-Equity Ratio in Practice
Suppose that GE’s target debt-equity ratio is 70%-30%. It is unlikely that
GE will raise funds with a 70-30 debt-equity split for every project. For
example, for the Brazilian project, GE is using a 60-40 D/E split.
The target (D/V)* reflects an average; it is not a hard target for each
project. That is, for other projects GE will use D/E to compensate and be
close to the (D/V)*.
Determinants of Cost of Capital for MNCs
Intuition: Economic factors that make the CFs of a firm more stable
reduce the kc.
1) Size of Firm (larger firms get better rates from creditors and have
lower s)
2) Access to international markets (better access, more chances of
finding lower rates)
3) Diversification (more diversification, more stable CFs, lower rates.
Also, s closer to M)
4) Fixed costs (the higher the proportion of fixed costs, the higher the )
5) Type of firm (cyclical companies have higher s)
6) FX exposure (more exposure, less stable CFs, worse rates)
7) Exposure to CR (again, more exposure to CR, less stable CFs, worse
rates).
Example: Cost of Capital (Nov 2014):
General Electric (GE): Huge, internationally diversified company
Disney (DIS): Large, moderate degree of international diversification
The GAP (GPS): Medium cap, low international diversification.
US Treasuries (kf): 1.63%
(5-year T-bill rate, from Bloomberg)
S&P 500 return (km): 8.433% (30 years: 1984-2014, from Yahoo)
tax rate (t): 27.9%
(effective U.S. tax rate, according to World Bank)
Recall: kc = D/(E+D) kd (1-t) + E/(E+D) ke
E
GE
DIS
GPS
D
Rating Spread
135B 313B AA- 27
45.5B 16.1B A+
30
3B
1.4B BBB- 168

1.24
0.96
1.65
kd
ke
WACC
1.90
1.93
3.31
10.07 3.99
8.16 6.39
12.86 9.53
(3) Valuation by Multiples
Calculation of the fair value of a company: Need rj = discount rate.
rj = bond yields (risk-free) + risk premium.
Example: For well-established markets, real bond yields are about 3%.
No consensus about the risk premium: from 0 to 8%.
 Alternative method: discount free cash flows (CF) (CF derived from
ordinary after-tax earnings).
CF: after interest, tax, and capital expenditures, but before depreciation
and amortization.
Assumptions:
(A) Two downward adjustments (1/3 of earnings, E):
(1) cost of replacing worn-out assets is higher than original (10)
(2) Companies invest also to expand (25%).
(B) Corporate earnings grow with trend economic growth (g).
• Now, we can calculate fair value stock prices:
P = CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 + ....,
where
CFt = 2/3 Et.
Et = E (1+g)t
P = 2/3 E(1+g)/(1+r) + 2/3 E(1+g)2/(1+r)2 + 2/3 E(1+g)3/(1+r)3 ..
This formula simplifies to:
P = 2/3E [(1+g)/(1+r)] / [1 -(1+g)/(1+r)].
Example: It is 1994. Calculating the steady state P/E for the U.S.
Data:
(1) Real economic trend growth (g) is 2.5% a year.
(2) Real bond yield is 3%
(3) Risk premium is 3%.
From (2) and (3)
 r = discount rate = 6%.
Recall: CF = 2/3 E
P = 2/3E [(1+g)/(1+r)] / [1 -(1+g)/(1+r)].
Then,
P/E = 2/3 [1.025/1.06]/[1 - (1.025/1.06)] = 2/3 (.96698)/(.0330189)
= 19.52
(equal to the P/E for 1994). ¶
Problem: Global economy is not in a steady state. Growth rates change
over time: Over the business cycle, profits take different proportions
of the GNP.
Example: When countries are in the advanced stages of the business
cycle, wages rise at a faster pace. P/E ratios have to be adjusted.
Example: Ad-hoc adjustments.
U.S. economy: late stages of the business cycle.
 Adjust steady state P/E by .80.
Asian Pacific Countries: room for improving the efficiency of firms.
 Adjust steady state P/E by 1.10. ¶