Chapter 11
Global Cost and Availability of Capital
T Questions
Dimensions of the cost and availability of capital
1.
Global integration has given many firms access to new and cheaper sources of funds beyond those
available in their home markets. What are the dimensions of a strategy to capture this lower cost and
greater availability of capital?
Global integration of capital markets has given many firms access to new and cheaper sources of
funds beyond those available in their home markets. These firms can then accept more long-term
projects and invest more in capital improvements and expansion. If a firm resides in a country with
illiquid and/or segmented capital markets, it can achieve this lower global cost and greater
availability of capital by a properly designed and implemented strategy.
Benefits
2.
What are the benefits of achieving a lower cost and greater availability of capital?
A firm can accept more long term projects and invest more in capital improvements and expansion
because of the lower hurdle rate in capital budgeting and the lower marginal cost of capital as more
funds are raised.
Definitions
3.
Define the following terms:
(a) Systematic risk. Systematic risk is the risk of share price changes that can not be avoided by
diversification. In other words, it is the risk that the stock market as a whole will rise or fall and
the price of shares of an individual company will rise and fall with the market. Systematic risk is
sometimes called market risk.
(b) Unsystematic risk. Unsystematic risk is risk that can be avoided by diversification. It arises
because some of the characteristics of a given company are peculiar to that company, causing it
to perform in a way that differs from the performance of the market as a whole. Unsystematic
risk is also called unique risk, residual risk, specific risk, or diversifiable risk.
Chapter 11
Global Cost and Availability of Capital
209
(c) Beta (in the Capital Asset Pricing Model). Beta is a measure of the systematic risk of a firm,
where “systematic risk” means that risk that cannot be diversified away. Beta measures the
amount of fluctuation expected in a firm’s share price, relative to the stock market as a whole.
Thus a beta of 0.8 would indicate an expectation that the share price of a given company would
rise or fall at 80% of the rise or fall in the stock market in general. The stock is expected to be
less volatile than the market as a whole. A beta of 1.6 would indicate an expectation that the
share price of a given company would rise or fall at 60% more that the rise or fall in the market.
If the market rose, say, 20% during a year, a stock with a beta of 1.6 would be expected to rise
(0.20)(1.6) = 0.32, or 32%.
4.
Equity risk premiums.
(a) What is an equity risk premium? The equity risk premium is the average annual return of the
market expected by investors over and above riskless debt, the term (km – krf).
(b) What is the difference between calculating an equity risk premium using arithmetic returns
compared to geometric returns? The mean arithmetic return is simply the average of the annual
percentage changes in capital appreciation plus dividend distributions. This is a rate of return
calculation with which every business student is familiar. The mean geometric return, however,
is a more specialized calculation which takes into account only the beginning and ending values
over an extended period of history. It then calculates the annual average rate of compounded
growth to get from the beginning to the end, without paying attention to the specific path taken in
between.
(c) In Exhibit 11.3, why are arithmetic mean risk premiums always higher than geometric
mean risk premiums? The geometric change is calculated using only the beginning and ending
1/4
1/4
values, 10 and 14, and the geometric root of [(14/10) –1 ] is found (the is in reference to 4
periods of change). The geometric change assumes reinvested compounding, whereas the
arithmetic mean only assumes point to point investment.
Portfolio investors
5.
Both domestic and international portfolio managers are asset allocators.
(a) What is their portfolio management objective? Both domestic and international portfolio
managers are asset allocators. Their objective is to maximize a portfolio’s rate of return for a
given level of risk, or to minimize risk for a given rate of return. International portfolio managers
can choose from a larger bundle of assets than portfolio managers limited to domestic-only asset
allocations.
(b) What is the main advantage that international portfolio managers have compared to
portfolio managers limited to domestic-only asset allocation? Internationally diversified
portfolios often have a higher expected rate of return, and they nearly always have a lower level
of portfolio risk, since national securities markets are imperfectly correlated with one another.
Dimensions of asset allocation
6.
Portfolio asset allocation can be accomplished along many dimensions depending on the investment
objective of the portfolio manager. Identify the various dimensions.
Portfolio asset allocation can be accomplished along many dimensions depending on the investment
objective of the portfolio manager. For example, portfolios can be diversified according to the type of
securities. They can be composed of stocks only or bonds only or a combination of both. They also
can be diversified by industry or by size of capitalization (small-cap, mid-cap, and large-cap stock
portfolios).
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For our purposes, the most relevant dimensions are diversification by country, geographic region,
stage of development, or a combination of these (global). An example of diversification by country is
the Korea Fund. It was at one time the only vehicle for foreign investors to hold South Korean
securities, but foreign ownership restrictions have more recently been liberalized. A typical regional
diversification would be one of the many Asian funds. These performed exceptionally well until the
“bubble” burst in Japan and Southeast Asia during the second half of the 1990s. Portfolios composed
of emerging market securities are examples of diversification by stage of development. They are
composed of securities from different countries, geographic regions, and stage of development.
7.
Market liquidity.
(a) Define what is meant by the term market liquidity. Although no consensus exists about the
definition of market liquidity, we can observe market liquidity by noting the degree to which a
firm can issue a new security without depressing the existing market price, as well as the degree
to which a change in price of its securities elicits a substantial order flow.
(b) What are the main disadvantages for a firm to be located in an illiquid market? An illiquid
market is one in which it is difficult to buy or sell shares, and especially an abnormally large
number of shares, without a major change in price. From a company perspective, an illiquid
market is one in which it is difficult to raise new capital because there are insufficient buyers for
a reasonably sized offering. From an investors perspective, an illiquid market means that the
investor will have difficulty selling any shares owned without a major drop in price.
(c) If a firm is limited to raising funds in its domestic capital market, what happens to its
marginal cost of capital as it expands? The marginal cost of capital increases as more funds are
raised.
(d) If a firm can raise funds abroad what happens to its marginal cost of capital as it expands?
The marginal cost of capital stays flat for a longer range of raising new capital.
8.
Market segmentation.
(a) Define market segmentation. Firms resident in countries with segmented capital markets must
devise a strategy to escape dependence on that market for their long-term debt and equity needs.
A national capital market is segmented if the required rate of return on securities in that market
differs from the required rate of return on securities of comparable expected return and risk
traded on other securities markets. Capital markets become segmented because of such factors as
excessive regulatory control, perceived political risk, anticipated foreign exchange risk, lack of
transparency, asymmetric availability of information, cronyism, insider trading, and many other
market imperfections.
(b) What are the six main causes of market segmentation? Capital market segmentation is a
financial market imperfection caused mainly by government constraints, institutional practices,
and investor perceptions. The most important imperfections are:
•
•
•
•
•
•
•
Asymmetric information between domestic and foreign-based investors
Lack of transparency
High securities transaction costs
Foreign exchange risks
Political risks
Corporate governance differences
Regulatory barriers
Chapter 11
Global Cost and Availability of Capital
211
(c) What are the main disadvantages for a firm to be located in a segmented market? Firms
located in a segmented market usually have a higher cost of capital (increasing marginal cost of
capital) and less availability of capital. They can overcome these limitations by following a
proactive strategy to internationalize their cost and availability of capital.
Market liquidity and segmentation effects
9.
What is the effect of market liquidity and segmentation on a firm’s cost of capital?
Firms located in an illiquid and segmented capital market will usually have a higher marginal cost of
capital.
Novo Industri (A)
10. Why did Novo believe its cost of capital was too high compared to its competitors? Why did Novo’s
relatively high cost of capital create a competitive disadvantage?
Novo observed that its price/earnings ratio was only 5 compared to 15 and higher for its competitors.
Novo was also told by its bankers that they could not borrow much more and the domestic equity
market was saturated with respect to Novo’s stock. Novo’s high cost and low availability of capital in
Denmark would prevent it from fully exploiting its competitive advantage in research on insulin and
industrial enzymes.
Novo Industri (B)
11. Novo believed that the Danish capital market was segmented from world capital markets. Explain the
six characteristics of the Danish equity market that were responsible for its segmentation.
At least six characteristics of the Danish equity market were responsible for market segmentation:
(1) asymmetric information base of Danish and foreign investors, (2) taxation, (3) alternative sets of
feasible portfolios, (4) financial risk, (5) foreign exchange risk, and (6) political risk.
12. Novo Industri (C).
(a) What was Novo’s strategy to internationalize its cost of capital? Novo’s strategy was to
increase its level and the quality of its financial and technical disclosure in both Danish and
English in order to attract foreign portfolio investors.
(b) What is the evidence that Novo’s strategy succeeded? Between April 1980, when its
disclosure was being maximized, and December 1986 Novo’s stock price increased from
Dkr2000 per share to Dkr600 per share. Its P/E ratio increased from 5 to 16, which was then in
line with its competitors.
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Emerging markets
13. It has been suggested that firms located in illiquid and segmented emerging markets could follow
Novo’s proactive strategy to internationalize their own cost of capital. What are the preconditions that
would be necessary to succeed in such a proactive strategy?
The Novo experience has been described in hopes that it can be a model for other firms wishing to
escape from segmented and illiquid home equity markets. In particular MNEs based in emerging
markets often face barriers and lack of visibility similar to what Novo faced. They could benefit by
following Novo’s proactive strategy employed to attract international portfolio investors. However, a
word of caution is advised. Novo had an excellent operating track record and a very strong worldwide
market niche in two important industry sectors, insulin and industrial enzymes. This record continues
to attract investors in Denmark and abroad. Other companies would also need to have such a
favorable track record to attract foreign investors.
Cost of capital for MNEs compared to domestic firms
14. Theoretically MNEs should be in a better position than their domestic counterparts to support higher
debt ratios because their cash flows are diversified internationally. However, recent empirical studies
have come to the opposite conclusion. These studies also concluded that MNEs have higher betas
than their domestic counterparts.
(a) According to these empirical studies why do MNEs have lower debt ratios than their
domestic counterparts? Despite the theoretical elegance of this hypothesis, empirical studies
have come to the opposite conclusion. Despite the favorable effect of international diversification
of cash flows bankruptcy risk was only about the same for MNEs as for domestic firms.
However, MNEs faced higher agency costs, political risk, foreign exchange risk, and asymmetric
information. These have been identified as the factors leading to lower debt ratios and even a
higher cost of long-term debt for MNEs. Domestic firms rely much more heavily on short and
intermediate debt, which lie at the low cost end of the yield curve.
(b) According to these empirical studies why do MNEs have higher betas than their domestic
counterparts? One study found that MNEs have a higher level of systematic risk than their
domestic counterparts. The same factors caused this phenomenon as caused the lower debt ratios
for MNEs. The study concluded that the increased standard deviation of cash flows from
internationalization more than offset the lower correlation from diversification.
Chapter 11
Global Cost and Availability of Capital
213
The “riddle”
15. The riddle is an attempt to explain under what conditions an MNE would have a higher or lower debt
ratio and beta than its domestic counterpart. Explain and diagram what are these conditions.
The answer to this riddle lies in the link between the cost of capital, its availability, and the
opportunity set of projects. As the opportunity set of projects increases, eventually the firm needs to
increase its capital budget to the point where its marginal cost of capital is increasing. The optimal
capital budget would still be at the point where the rising marginal cost of capital equals the declining
rate of return on the opportunity set of projects. However, this would be at a higher weighted average
cost of capital than would have occurred for a lower level of the optimal capital budget.
To illustrate this linkage Exhibit 11.8 shows the marginal cost of capital given different optimal
capital budgets. Assume that there are two different demand schedules based on the opportunity set of
projects for both the multinational enterprise (MNE) and domestic counterpart (DC).
Emerging market MNEs
16. Apart from improving liquidity and escaping from a segmented home market, why might emerging
market MNEs further lower their cost of capital by listing and selling equity abroad?
A recent study found that internationalization actually allowed emerging market MNEs to carry a
higher level of debt and lowered their systematic risk. This occurred because the emerging market
MNEs are investing in more stable economies abroad, a strategy that lowers their operating, financial,
foreign exchange, and political risks. The reduction in risk more than offsets their increased agency
costs and allows the emerging market MNEs to enjoy higher leverage and lower systematic risk than
their U.S.-based MNE counterparts.
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T Mini-Case: Nestle: An Application of the International CAPM
1.
There are a multitude of barriers to the free and open movement of capital across boundaries. How
would these barriers effect professional investors and portfolio managers with respect to new
information regarding the return and risk prospects of individual securities globally?
It depends on the type of barriers. For example, in Novo’s case the barriers were mainly lack of
interest by international investors because the Danish equity market was too small, segmented, and
illiquid. However, there were no Danish legal or institutional barriers that would have prevented
international investors from buying Novo’s shares. In Nestle’s case, professional investors and
portfolio managers are already very familiar with Nestle, which has previously internationalized its
investor base. Therefore, there should be no significant barriers to the free movement of capital into
and out of Nestle’s shares by international and professional investors.
2.
Given such market imperfections as limitations on trading, illiquidity, and lack of perfect information
in many emerging markets, is there any way to measure or define an international or global portfolio?
A number of firms resident in emerging markets have already internationalized their investor base
and cost of capital. These firms should be included in the global portfolio. Purely domestic firms that
appeal only to local investors should probably not be included in the definition of potential global
portfolio stocks. However these domestic firms could change that conclusion if they choose to take
the Novo route and try to internationalize their investor base.
3.
The international CAPM uses the risk-free rate of interest as its base. Under what conditions could
you calculate a risk-free rate of return globally?
A risk-free rate must be exactly that: a rate of return which has no currency risk, market risk (danger
to principal or liquidation value from market price movements), or credit risk. A risk-free rate for any
portfolio must therefore be a government issuance of relatively short maturity (to truly eliminate
market risk) and be of a home currency value. Until the world possesses either a single currency or a
operates a system of secure fixed exchange rates (a state of second-best to a single currency), there is
no real “global risk-free rate.”
Chapter 11
Global Cost and Availability of Capital
T Problems
Problem 11.1 Houston Oil Company
What is Houston’s weighted average cost of capital?
Assumptions
Houston’s beta
Cost of debt, before tax
Risk-free rate of interest
Corporate income tax rate
General return on market portfolio
Optimal capital structure:
Proportion of debt, D/V
Proportion of equity, E/V
a)
Values
1.10
7.000%
3.000%
25.000%
8.000%
b)
Values
0.80
7.000%
3.000%
25.000%
8.000%
60%
40%
60%
40%
5.250%
5.250%
8.500%
7.000%
6.550%
5.950%
Calculation of the WACC
Cost of debt, after-tax
kd × (1 − t)
Cost of equity, after-tax
ke = krf + (km − krf) β
WACC
WACC = [ke × E/V] + [(kd × (1 − t)) × D/V]
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 11.2 Trident’s cost of capital
Calculate the cost of equity, debt, and WACC.
Original assumptions in Chapter
Trident’s beta, β
Cost of debt, before tax, kd
Risk-free rate of interest, krf
Corporate income tax rate, t
General return on market portfolio, km
Optimal capital structure:
Proportion of debt, D/V
Proportion of equity, E/V
a) Trident’s cost of equity
ke = krf + (km − krf) β
b) Trident’s cost of debt, after tax
kd × (1 − t)
c) Trident’s weighted average cost of capital
WACC = [ke × E/V] + [(kd × (1 − t)) × D/V]
Values used
in Chapter
1.20
8.00%
5.00%
35.00%
15.00%
New Values
1.30
7.000%
4.000%
30.000%
9.000%
40%
60%
50%
50%
17.000%
10.500%
5.200%
4.900%
12.2800%
7.7000%
One of the most interesting aspects of capital costs is how they have been trending downward
in recent years as a result of lower interest rates, lower equity market returns, and in some
countries, lower tax rates. As a result of the general decline in business and economic
performance, many firms have been reducing their debt levels—if possible—in roder to reduce
their debt service requirements. But, one factor which has not necessarily fallen in value is the
beta of the individaul firm. Here Trident’s cost of capital has fallen dramatically, but its beta is
actually higher than before due to more market volatility.
Problem 11.3 Sunshine Pipelines Inc.
Assumptions
Combined federal and state tax rate
Desired capital structure:
Proportion debt
Proportion equity
Capital to be raised
Values
40%
Cost of
European
Equity
14%
16%
24%
Cost of
European
Debt
6%
10%
18%
a. To raise $120,000,000
Debt Market
Debt Cost
Equity Market
Equity Cost
European
European
Domestic
6.00%
10.00%
16.00%
10.67%
(equal weights)
Debt Market
Debt Cost
European
European
6.00%
10.00%
7.33%
(2/3 & 1/3 weights)
First $40,000,000
Second $40,000,000
Third $40,000,000
Weighted average cost
b. To raise $60,000,000
First $40,000,000
Additional $20,000,000
Weighted average cost
Domestic
European
Domestic
Equity Market
Domestic
European
12.00%
16.00%
22.00%
16.67%
(equal weights)
Equity Cost
12.00%
16.00%
13.33%
(2/3 & 1/3 weights)
Incremental
WACC
7.80%
11.00%
15.80%
11.53%
Incremental
WACC
7.80%
11.00%
8.87%
Global Cost and Availability of Capital
Cost of
Domestic
Debt
8%
12%
16%
Chapter 11
Costs of Raising Capital in the Market
Up to $40 million of new capital
$41 million to $80 million of new capital
Above $80 million
50%
50%
$120,000,000
Cost of
Domestic
Equity
12%
18%
22%
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 11.4 Tata’s cost of capital
Tata of India is trying to estimate its US dollar cost of capital.
Assumptions
Components of beta:
Estimate of correlation between security and market
Estimate of standard deviation of Tata’s returns
Estimate of standard deviation of market’s return
Risk-free rate of interest
Estimate of Tata’s cost of debt in US market
Estimate of market return, forward-looking
Corporate tax rate
Proportion of debt
Proportion of equity
Symbol
β
ρjm
σj
σm
krf
kd
km
t
D/V
E/V
Goldman Sachs Bank of New York
0.90
24.0%
18.0%
0.85
30.0%
22.0%
3.0%
7.5%
9.0%
35.0%
35%
65%
3.0%
7.8%
12.0%
35.0%
40%
60%
Estimating Costs of Capital
Estimated beta
β = (ρjm × σj)/(σm)
β
1.20
1.16
Estimated cost of equity
ke = krf + (km − krf)β
ke
10.200%
13.432%
kd (1 – t)
4.875%
5.070%
WACC
8.336%
10.087%
Estimated cost of debt
kd (1 − t)
Estimated weighted average cost of capital
WACC = (ke × E/V) + ((kd × (1 − t)) × D/V)
Chapter 11
Global Cost and Availability of Capital
Problem 11.5 Country equity risk premiums
Country
Australia
Belgium
Canada
Denmark
France
Germany
Ireland
Italy
Japan
Netherlands
South Africa
Spain
Sweden
Switzerland
United Kingdom
United States
World
Arithmetic Mean
Risk Premium
8.0%
4.8%
6.0%
3.3%
7.0%
9.9%
4.5%
8.4%
10.3%
6.7%
7.1%
4.2%
7.4%
4.2%
5.6%
7.0%
5.6%
Geometric Mean
Risk Premium
6.3%
2.9%
4.5%
2.0%
4.9%
6.7%
3.2%
5.0%
6.2%
4.7%
5.4%
2.3%
5.2%
2.7%
4.4%
5.0%
4.9%
Differential
1.7%
1.9%
1.5%
1.3%
2.1%
3.2%
1.3%
3.4%
4.1%
2.0%
1.7%
1.9%
2.2%
1.5%
1.2%
2.0%
0.7%
a) Japan demonstrates the largest differential between the arithmethic mean and
geometric mean; a full 4.1%.
b) A Swiss firm estimating its cost of equity using the capital asset pricing model,
would find the cost of equity as:
ke = krf + (km − krf) β where (km − krf) is the risk premium
Risk-free rate
Risk premium
beta
Cost of equity
Arithmetic
2.00%
4.20%
1.40
7.88%
Geometric
2.00%
2.70%
1.40
5.78%
219
220
Estimate the cost of capital for a privately held multinational.
Assumptions
Total sales
Company’s beta
Company credit rating
Risk-free rate of interest
Market risk premium
Weighted average cost of debt
Corporate tax rate
Debt to total capital ratio
Equity to total capital ratio
International sales as % of total sales
Symbol
Sales
β
S&P
krf
km − krf
kd
t
D/V
E/V
Comparables
Company A
Company B
$4.5 billion
$26 billion
0.86
0.78
AA
A
2.5%
2.5%
5.5%
5.5%
6.885%
7.125%
40.0%
40.0%
34%
41%
66%
59%
12%
26%
Estimating Costs of Capital
Cost of equity
ke = krf + (km − krf) β
Symbol
Company A
Company B
Cargill
ke
7.230%
6.790%
7.450%
Cost of debt, after-tax
kd (1 − t)
4.131%
4.275%
4.092%
Cargill
$50 billion
0.90
AA
2.5%
5.5%
6.820%
40.0%
28%
72%
45%
WACC
Weighted average cost of capital
6.176%
5.759%
6.510%
WACC = (ke × E/V) + ((kd × (1 − t)) × D/V)
Once the data is organized, the absence of a beta for Cargill is the obvious data deficiency.
A series of observations is then helpful:
1. Note that beta and credit ratings do not necessarily parallel one another
2. Credit rating and cost of debt do follow expected norms; lower the rating, the higher the cost
3. Both comparable companies, in the same industry as Cargill (commodities), possess relatively low betas
4. Cargill’s sales are twice that of the next largest firm
5. Cargill’s sales are significantly more internationally diversified than either of the other two companies; the question
is whether this is a positive or negative factor for the estimation of Cargill’s cost of equity?
If we take the approach that the beta for Cargill has to pick up all the incremental information, the beta would then fall
between say 0.80 and 1.00. If the higher degree of international sales was interpreted as increasing risk, beta would
be on the higher end; yet being a commodity firm in the current market, its beta would rarely surpass 1.0. A value of
0.90 is shown here giving a WACC of 6.510%. A series of sensitivities would find a WACC between 6.1% and 6.9%.
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 11.6 Cargill’s cost of capital
Problem 11.7 The Tombs
Is Larry, Mo, or Curly right in their debate at The Tombs?
Brazilian Economic Performance
Inflation rate (IPC)
Bank lending rate
Exchange rate (reais/$)
Equity returns (Sao Paulo Bovespa)
1995
23.20%
53.10%
0.972
16.0%
1996
10.00%
27.10%
1.039
28.0%
1997
4.80%
24.70%
1.117
30.2%
1998
−1.00%
29.20%
1.207
−33.5%
1999
10.50%
30.70%
1.700
151.9%
Mean
9.50%
32.96%
120.7%
38.52%
All three are on the right track. It is mostly a matter of finding the linkages beween their individual arguments.
3. Larry also is on the right track arguing that actual market returns will often result in less than various interest or debt instruments. One of
the more helpful arguments here is that equity returns and interest returns arise from very different economic and financial processes.
Most interest rate charges are stated and contracted for up-front, and represent lenders’ perception of an adequate risk-adjusted return over
the expected rate of inflation for the coming period. Equity returns, however, are that mystical process of equity markets in which
the many different reasons of equity investors combine to move markets in sometimes mysterious ways, independent of interest rates,
inflation rates, or any other fundamental money price.
Global Cost and Availability of Capital
2. Mo is also correct in arguing that regardless of what investors may EXPECT, the results are often quite different, sometimes
disappointing. Theoretically, when the investment does not yield at least the expected return, the investor should indeed liquidate their
position. However, in reality, many investors for a variety of reasons (tax implications, investment horizon, etc.), may stay in the investment
and just complain about the past and hope about the future.
Chapter 11
1. Theoretically, Curly is correct in that CAPM assumes that all equity returns are over and above risk-free rates. These are of course,
expected returns, and are the investor’s expectations or requirements going INTO the investment.
221
222
Sushmita-Chen is attempting to gauge the impact of international diversification on its cost of capital.
Assumptions
Correlation between S-C and the market
Standard deviation of S-C’s returns
Standard deviation of market’s returns
Risk-free rate of interest
Additional equity risk premium for internationalization
Estimate of Tata’s cost of debt in US market
Market risk premium
Corporate tax rate
Proportion of debt
Proportion of equity
Symbol
ρjm
σj
σm
krf
RPM
kd
km − krf
t
D/V
E/V
Before
Diversification
0.88
28.0%
18.0%
3.0%
0.0%
7.2%
5.5%
35.0%
38%
62%
After
Diversification
0.76
26.0%
18.0%
3.0%
3.0%
7.0%
5.5%
35.0%
32%
68%
Estimating Costs of Capital
Estimated beta
β = (ρjm × σj)/(σm)
β
1.37
1.10
Estimated cost of equity
ke = krf + (km − krf) β
ke
10.529%
9.038%
Estimated cost of equity with additional risk premium
*
10.529%
12.038%
ke = krf + (km − krf) β + RPM
ke + RPM
This may be a case where everyone is correct. When Sushmita-Chen’s beta is recalculated, it falls in value as a result
of the reduced correlation of its returns with the home market (diversification benefit). This then creates a standard cost
of equity which is cheaper at 9.038% (previous cost of equity was 10.529%).
If, however, the market was to add an additional risk premium to the firm’s cost of equity as a result of internationally
diversifying operations, and if that risk premium were on the order of 3.0%, the final risk-adjusted cost of equity is
indeed higher, 12.038% to the before value of 10.529%.
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 11.8 Sushmita-Chen’s cost of equity
Problem 11.8 Sushmita-Chen’s cost of equity
Sushmita-Chen is attempting to gauge the impact of international diversification on its cost of capital.
Assumptions
Correlation between S-C and the market
Standard deviation of S-C’s returns
Standard deviation of market’s returns
Risk-free rate of interest
Additional equity risk premium for internationalization
Estimate of Tata’s cost of debt in US market
Market risk premium
Corporate tax rate
Proportion of debt
Proportion of equity
Symbol
ρjm
σj
σm
krf
RPM
kd
km − krf
t
D/V
E/V
Before
Diversification
0.88
28.0%
18.0%
3.0%
0.0%
7.2%
5.5%
35.0%
38%
62%
After
Diversification
0.76
26.0%
18.0%
3.0%
3.0%
7.0%
5.5%
35.0%
32%
68%
Chapter 11
Estimating Costs of Capital
β
1.37
1.10
Estimated cost of equity
ke = krf + (km − krf) β
ke
10.529%
9.038%
Estimated cost of equity with additional risk premium
*
10.529%
12.038%
ke = krf + (km − krf) β + RPM
ke + RPM
This may be a case where everyone is correct. When Sushmita-Chen’s beta is recalculated, it falls in value as a result
of the reduced correlation of its returns with the home market (diversification benefit). This then creates a standard cost
of equity which is cheaper at 9.038% (previous cost of equity was 10.529%).
If, however, the market was to add an additional risk premium to the firm’s cost of equity as a result of internationally
diversifying operations, and if that risk premium were on the order of 3.0%, the final risk-adjusted cost of equity is
indeed higher, 12.038% to the before value of 10.529%.
Global Cost and Availability of Capital
Estimated beta
β = (ρjm × σj)/(σm)
223
224
Problem 11.9 Sushmita-Chen’s WACC
Estimated cost of equity
ke = krf + (km − krf) β
Estimated cost of equity with additional risk premium
*
ke = krf + (km − krf) β + RPM
Cost of debt, after-tax
kd (1 − t)
Weighted average cost of capital
WACC = (ke × E/V) + ((kd × (1 − t)) × D/V)
Weighted average cost of capital with RPM
*
WACC = (ke × E/V) + ((kd × (1 − t)) × D/V)
After
Diversification
0.76
26.0%
18.0%
3.0%
3.0%
7.0%
5.5%
35.0%
32%
68%
After
Diversification
1.10
ke
10.529%
9.038%
ke + RPM
kd (1 − t)
10.529%
12.038%
4.680%
4.550%
8.306%
7.602%
8.306%
9.642%
WACC
*
WACC
There are a number of different factors at work here. First, as a result of international diversification, their access to debt
has improved, resulting in a lower cost of debt capital. This is not fully appreciated, however, as the firm has chosen to
reduce its overall use of debt post-diversification (common among MNEs).
The firm’s WACC does indeed drop for the standardized case. If, however, the market assesses an additional equity risk
premium of 3.0%, the benefits are swamped by the higher required return on equity by the market.
Moffett • Fundamentals of Multinational Finance, Second Edition
Sushmita-Chen is attempting to gauge the impact of international diversification on its cost of capital.
Before
Assumptions
Symbol
Diversification
Correlation between S-C and the market
ρjm
0.88
Standard deviation of S-C’s returns
σj
28.0%
Standard deviation of market’s returns
σm
18.0%
Risk-free rate of interest
krf
3.0%
Additional equity risk premium for internationalization
RPM
0.0%
Estimate of Tata’s cost of debt in US market
kd
7.2%
Market risk premium
km − krf
5.5%
Corporate tax rate
t
35.0%
Proportion of debt
D/V
38%
Proportion of equity
E/V
62%
Before
Estimating Costs of Capital
Diversification
Estimated beta
β = (ρjm × σj)/(σm)
β
1.37
Problem 11.10 Sushmita-Chen’s WACC and effective tax rate
Sushmita-Chen is attempting to gauge the impact of international diversification on its cost of capital.
Assumptions
Correlation between S-C and the market
Standard deviation of S-C’s returns
Standard deviation of market’s returns
Risk-free rate of interest
Additional equity risk premium for internationalization
Estimate of Tata’s cost of debt in US market
Market risk premium
Corporate tax rate
Proportion of debt
Proportion of equity
Symbol
ρjm
σj
σm
krf
RPM
kd
km − krf
t
D/V
E/V
Estimating Costs of Capital
Before
Diversification
0.88
28.0%
18.0%
3.0%
0.0%
7.2%
5.5%
35.0%
38%
62%
After
Diversification
0.76
26.0%
18.0%
3.0%
3.0%
7.0%
5.5%
32.0%
32%
68%
Before
Diversification
After
Diversification
1.37
1.10
Estimated cost of equity
ke = krf + (km − krf) β
ke
10.529%
9.038%
ke + RPM
kd (1 − t)
10.529%
12.038%
4.680%
4.760%
8.306%
7.669%
8.306%
9.709%
Estimated cost of equity with additional risk premium
*
ke = krf + (km − krf) β + RPM
Cost of debt, after-tax
kd (1 − t)
Weighted average cost of capital
WACC = (ke × E/V) + ((kd × (1 − t)) × D/V)
Weighted average cost of capital with RPM
*
WACC = (ke × E/V) + ((kd × (1 − t)) × D/V)
WACC
*
WACC
225
The reduction in the effective tax rate obviously impacts WACC through the cost of debt. This does have substantial
benefits in the company’s WACC—as long as additional equity risk premiums are not assessed. Then, even the lower
effective tax rate does not offset the higher equity costs associated with the international risk premium.
Global Cost and Availability of Capital
β
Chapter 11
Estimated beta
β = (ρjm × σj)/(σm)