Fin 4328 (Moore)
Chapter 14 Notes
The Cost of Capital for Foreign Investments
Chapter 14 Class Notes
THE COST OF CAPITAL FOR FOREIGN INVESTMENTS
I. THE COST OF EQUITY CAPITAL
A. Definition
1. The minimum (required) rate of return
necessary to induce investors to buy or hold the firm’s stock.
2. Used to value future equity cash flows.
3. Determines common stock price.
B. Capital Asset Pricing Model (CAPM) Formula
ri = r f
+ βi ( rm - rf )
where ri = the equity required rate
rf = the risk free return rate
βi = Cov(rm, ri)/ 2 rm where
Cov(rm, ri) is the covariance between asset and market
returns
2 rm
is the variance of market returns.
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Fin 4328 (Moore)
Chapter 14 Notes
II. THE WACC FOR FOREIGN PROJECTS
A. Weighted Average Cost of Capital (WACC) Formula
WACC AT =
where L
=
(1-L) ke + L kd (1 - t)
the parent’s debt ratio (MVL/MVA)
kd (1 - t) =
the after-tax debt cost
ke
the equity cost of capital
=
WACC AT is used as the discount rate in the calculation of NPV.
B. Two Observations
1. Weights must be a proportion using market, not book value.
2. Calculating WACC, weights should be marginal to reflect
future debt structure.
C. Costing Various Sources of Funds
1. Components of a New Investment (I)
I = P + Ef + Df
where
I =
require subsidiary financing
P =
dollars by parent
Ef =
subsidiary’s retained earnings
Df =
dollars from debt
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Fin 4328 (Moore)
Chapter 14 Notes
2. First compute each component
a. Parent’s company funds (WACC AT) required rate equal to
the marginal cost of capital
b. Retained Earnings (ke)
- In a perfect world, it’s a function of dividends,
withholding taxes, tax deferral, and transfer costs.
Where
ks = ke (1-T)
- Simplify. Assume financial managers minimize tax
exposure to zero
c. Local Currency Debt (kd,L)
- after-tax dollar cost of borrowing locally
3. Computing marginal WACC AT on new investment
WACC AT,new = WACC AT, old - L[ kd(1-t) - kd,L ]
III. THE ALL-EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS
A. WACC is sometimes awkward
1. Goal: to go from the parent to the project
2. Solution: Use all equity discount rate
3. To calculate:
k* = rf + *( rm - rf )
4. * is the all-equity beta associated with the unlevered cash
flows.
5. Unlevering beta obtained by
*= e (1 + (1-t)(D/E))
where B* =
D/E =
t
=
the firm’s stock price beta
the debt to equity ratio
the firm’s marginal tax
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Fin 4328 (Moore)
IV.
Chapter 14 Notes
DISCOUNT RATES FOR FOREIGN PROJECTS
A.
Systematic Risk
1. Not diversifiable.
2. Foreign projects in non-synchronous economies should be
less correlated with domestic markets.
3. Paradox: LDCs have greater political risk but offer higher
probability of diversification benefits.
B. Key Issues in Estimating Foreign Project Betas
- Find firms publicly traded that share similar risk characteristics.
- Use the average beta as a proxy.
1. Three Issues:
a.
Should proxies be U.S. or local companies?
b.
Which is the relevant base portfolio to use?
c.
Should the market risk premium be based on U.S. or
local market?
2. Proxy Companies
a.
Most desirable to use local firms
b.
Alternative: Find proxy industry in local market.
3. Relevant Base (Market) Portfolio
a. If capital markets globally integrated, choose world mkt.
b. If not, domestic portfolio is best
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Fin 4328 (Moore)
Chapter 14 Notes
4. Relevant Market Risk Premium
a. Use the U.S. portfolio
b. Foreign project: should be no higher than domestic risk.
V. ESTABLISHING A WORLDWIDE CAPITAL STRUCTURE
A. MNC Advantage
Uses more debt due to diversification.
B. What is proper capital structure?
1. Borrowing in local currency helps to reduce exchange rate risk.
2. Allow subsidiary to exceed parent capitalization norm if local
mkt. has lower costs.
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Fin 4328 (Moore)
Chapter 14 Notes
CHAPTER 14 - Questions
EASY (factual)
14.1 The ________ for a given investment is the minimum riskadjusted return required by the shareholders of the firm for
undertaking that investment.
a. cost of equity capital
b. systematic risk
c. all-equity beta
d. weighted average cost of capital
14.2 One function of the cost of capital is to ________ for the firm.
a. determine the debt to equity ratio
b. value future cash flows
c. determine the current ratio
d. determine the current lending rate
14.4 When the cost of equity capital is combined with after-tax cost of
debt, the result yields the
a. all-equity beta
b. cost of capital
c. weighted average cost of capital
d. target capital structure
14.6 Systematic risk is that portion of return variability that
a. can be eliminated through diversification
b.
cannot be eliminated unless fixed income securities are
added to the portfolio
c. can be reduced but not eliminated
d. cannot be eliminated through diversification
14.7 To avoid the awkward process of going from the parent to the
subsidiary cost of capital, it is advisable to use the _______ rate.
a. prime market interest
b. all-equity discount
c. all-debt discount
d. both the equity and debt discount
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Fin 4328 (Moore)
Chapter 14 Notes
14.8 LDCs have greater ______ risk but offer higher probability of
diversification benefits.
a. economic
b. translation
c. political
d. operating
MODERATE (applied)
14.11 The cost of capital for a General Foods Jell-O plant in Venezuela
is likely to be
a.
lower than for a comparable plant in the U.S., because its
systematic risk is probably lower
b. higher than for a comparable U.S. plant because of the added
risks associated with the unstable economic and political
environment
c.
about the same. Systematic risk is likely to be very similar
d.
greatly impacted by the change in political parties in
neighboring Colombia
14.12 The cost of capital for a project in Australia should theoretically
a. equal the parent's weighted average cost of capital
b. equal the required return for a similar investment in the U.S.
c. equal the minimum rate of return necessary to induce investors to
buy or hold the firm's stock
d. depend on the riskiness of the project itself
14.13 Suppose that a foreign project has a beta of 1.12, the risk-free
return is 9.3% and the required return on the market is estimated
at 18%. Then the cost of capital for the project is
a. 17.21%
b. 21.37%
c. 19.04%
d. 20.03%
14.16 Which project is likely to entail the least systematic risk?
a. a Ford plant in Brazil producing engines for export to the U.S.
b. a Coca Cola plant in Brazil selling locally
c. a machine tool plant in Japan
d. a computer disk drive plant in Germany
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Fin 4328 (Moore)
Chapter 14 Notes
14.15 The rate(s) at which investors capitalize the returns on foreign
projects depends on all of the following EXCEPT
a.
whether shareholders are internationally diversified
b.
the relative costs of international diversification for the MNC
and for individual investors
c.
the extent to which domestic systematic risk is unsystematic
from a global standpoint
d.
the correlation between equity returns on different markets
14.22 Suppose that a foreign project has a beta of 1.15, the risk-free
return is 13% and the required return on the market is estimated
at 21%.Then the cost of capital for the project is
a. 24.2%
b. 22.2%
c. 19.3%
d. 15.4%
DIFFICULT (applied)
14.23 Consider a project that costs $1 million today but yields no
returns for several years. Once the project becomes productive, it
yields $250,000 annually forever. Suppose two firms are
examining this project, a Japanese firm with a cost of capital of
7% and a U.S. firm with a cost of capital of 13%. Approximately
how many more years than the U.S. firm would the Japanese firm
be willing to wait until the project starts generating cash?
a. 14 years
b. 5 years
c. 24 years
d. 3 years
14.24 Assume an average dividend payout rate of 100% for both U.S.
and Japanese companies. Suppose the average P/E ratio for
Japanese firms is 38 and 16 for U.S. firms. Based on the dividend
growth model, in order for Japanese and U.S. companies to have
the same average cost of equity capital, how much higher would
the Japanese annual earnings growth rate have to be?
a. 7.24%
b. 6.31%
c. 5.83%
d. 8.39%
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Fin 4328 (Moore)
Chapter 14 Notes
14.25 Assume an average dividend payout rate of 60% for U.S.
companies and 35% for Japanese companies. Suppose the
average P/E ratio for Japanese firms is 38 and 16 for U.S. firms.
Based on the dividend growth model, in order for Japanese
companies to have the same 12% average cost of equity capital
estimated for U.S. companies, how much higher would the
Japanese annual earnings growth rate have to be?
a. 8.74%
b. 3.45%
c. 7.60%
d. 2.83%
14.28 Capital structures of foreign affiliates should
a. conform to the standards set by local companies
b.
vary so as to take advantage of opportunities to reduce
overall risk and financing costs
c. be very similar to the parent's capital structure because this is
what determines the firm's risk profile
d. conform to the standards established by other foreign units
14.30 The principal advantage(s) of investing in foreign affiliates in
the form of debt instead of equity is to
a. reduce taxes
b. reduce the impact of currency controls
c. both a and b
d. there are no advantages
14.31 A U.S. company that has issued Euro bonds could hedge at least
part of the exchange risk associated with those bonds by
a. invoicing its exports to Germany in DM
b. invoicing its imports from Germany in DM
c. invoicing its exports to Germany in dollars
d. invoicing its imports from Germany in dollars
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