The Cost of Capital for Foreign Investments
P.V. Viswanath
International Corporate Finance
Learning Objectives
 How Capital Budgeting can differ in an
international context
 What is the traditional notion of Cost of Capital?
 How do we estimate the cost of equity and the cost
of debt in a domestic context?
 What is the relevance of who “owns” the company?
 How do we use proxy companies in estimating cost
of equity?
 What is the relevance of country risk?
 How do we estimate country risk?
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Capital Budgeting for Foreign
Investments
 Capital Budgeting in an international environment raises
issues that are not present in a domestic setup.


Cashflows depend on capital structure because of cheap loans from
foreign governments. This makes the cost of capital to the
corporation different from the opportunity cost of capital for
shareholders.
There are exchange-rate risks, country risks, multiple tiers of
taxation, and sometimes restrictions on repatriating income.
 In principle many of these issues can be resolved using an
adjusted present value approach, where the project is valued
as a stand-alone all equity project and impact of the the
different financing frictions are added to this base value.
 However, in practice, most firms use a NPV/IRR approach.
Hence we shall focus on computing the right cost of capital
to evaluate projects. P.V. Viswanath
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The cost of capital
 In what follows, we will assume that the subsidiary or
project cashflows have been restated in dollars. Hence the
issue is coming up with a discount rate that is appropriate
for dollar flows.
 One implication of this is that the correct riskfree rate to use
is a Treasury rate.
 In principle, the cost of capital used should be a forwardlooking rate. However, in practice, the components of the
cost of capital are often estimated using historical data.
 While this is unavoidable, historical estimates should be
used with care.
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The WACC
 If the financial structure and risk of a project is the same as that of
the entire firm, then the appropriate discount rate is the Weighted
Average Cost of Capital: WACC = ke(1-d) + id(1-t)d
 where

d = the firm’s debt-to-assets ratio (debt ratio)

id = before-tax cost of debt

ke = cost of equity

t = marginal tax rate of the firm
 In using the WACC for project selection, the value of d used must
be the target debt ratio.
 If the risk of a project is different, then it should be evaluated
using its own beta, and its own target debt-to-assets ratio, etc.
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The cost of equity
 According to the CAPM, the required rate of return
on an asset is given as:
Required ROR on asset i  R f   i [Market Risk Premium ]


Rf = risk-free rate
i = beta of asset i, a measure of its non-diversifiable
risk.
 In principle, the CAPM applies to all assets, but in
practice –


It is used to estimate the cost of equity
It is rarely used to estimate the cost of debt because it is
very difficult to estimate a beta for debt securities.
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The cost of debt
 In practice, the yield-to-maturity is used instead of
the required rate of return, for debt securities.
 Where the bond is not traded, and hence no implied
yield-to-maturity can be computed, firm-specific
variables, such as interest-coverage ratios are used
to generate synthetic bond ratings.
 Historical relationships between bond-ratings and
bond spreads over Treasuries are then used to come
to an estimate of the bond's yield-to-maturity.
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Cost of Equity for foreign projects
 If the firm's equity investors hold a diversified US portfolio,
then the beta should be computed for the new project with
respect to the US equity index (market portfolio) and the
required rate of return can be computed using the CAPM,
even though the project may be a foreign project.
 If the "US" firm's investors are really holding a globally
diversified portfolio, or if they are not restricted to the US
(and hence, once again, they hold globally diversified
portfolios), then it makes sense to compute an equity cost of
capital for them by using the global CAPM, i.e. computing
the beta for the new project using the global "market"
portfolio (and a global risk premium).
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Cost of Equity for foreign projects
 However, in practice,


US investors may not be globally diversified, and
It may be easier to obtain US data than global data
 Consequently, US MNEs often evaluate projects from
the viewpoint of a US investor, who is not diversified
internationally.
 Furthermore, a recent study (2004) showed that a cost
of capital estimated using a domestic CAPM model is
insignificantly different from a cost of capital computed
using global risk factors.
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Issues in estimating cost of capital for
foreign projects
 In order to estimate a beta for the foreign subsidiary, a history of
returns is required. Often this is not available. Hence, a proxy
may have to be used, for which such information is available.

Should corporate proxies be local companies or US companies?
 The beta is the estimated slope coefficient from a regression of
the stock returns against a base portfolio, which is the global
market portfolio, according to the CAPM. However, this assumes
that markets are integrated.


In practice, is the relevant base portfolio against which proxy betas
are to be estimated, the US market portfolio, the local portfolio, or
the world market portfolio?
Should the market risk premium be based on the US market or the
local market or the world market?
 How should country risk be incorporated in the cost of capital?
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Using Proxy Companies to estimate beta
 Since we want a proxy as similar as possible to the project in
question, it makes sense that we use a local company.
 The return on an MNC’s local operations will depend on the
evolution of the local economy.
 Using a US proxy is likely to produce an upward biased estimate for
the beta.
 This can be seen by looking at the definition of the foreign market
beta with respect to the US market:
Foreign Market
beta

Correlatio n with US mkt x Std. dev. of foreign mkt
std. dev. of US mkt
 Foreign companies are likely to have lower correlation with the US
market than US companies.
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Using Proxy Companies to estimate beta
 If foreign proxies in the same industry are not available (say
because of data issues), then a proxy industry in the local
market can be used, whose beta is expected to be similar to
the beta of the project’s US industry.
 Alternatively, compute the beta for a proxy US industry and
multiply it by the unlevered beta of the foreign country
relative to the US. This will be valid, if:


The US beta for the industry is the same as that of that industry in
the foreign market as well, and
The only correlation, with the US market, of a foreign company in
the project’s industry is through its correlation with the local market
and the local market’s correlation with the US market.
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The Relevant Market Risk Premium
 Although, in principle, it may be appropriate to use a global
market portfolio, in practice, we use the US market
portfolio, for several reasons:


the small amount of international diversification of US investor
portfolios
since US projects are evaluated using a US base portfolio, use of a
US base portfolio means that foreign projects can be easily
compared to a US project.
 Correspondingly, a market risk premium based on the US
market is used, as well.
 US markets have much more historical data available, and it
is a lot easier to estimate forward-looking risk premiums for
the US market. However, the US market risk premium is
often adjusted to take country risk premiums into account.
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Country Risk Premiums
 The previous approaches that use US base portfolios and/or
US proxies effectively ignore country risk, assuming that it
is diversifiable. However, this may not be the case. In fact,
with globalization, cross-market correlations have increased,
leading to less diversifiability for country risk.
 Furthermore, it may not be enough to look at the beta alone
of a foreign project's beta, because this only deals with
contribution to volatility.
 Skewness or catastrophic risk may be significant in the case
of emerging markets. The impact of a project on the
negative skewness of the equityholder's portfolio could be
significant and should be taken into account.
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Country Risk Premiums
 For example, India's beta could be negative, but it
would not be appropriate to discount Indian projects at
less than the US risk-free rate.
 If investors do not like negative skewness (i.e. the
likelihood of catastrophic negative returns), we should
augment the CAPM with a skewness term.
 An alternative would be to estimate a country risk
premium based on the riskiness of the country relative
to a maturity market like the US, and to incorporate this
into the cost of equity of the project.
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Estimating Country Premiums
 Country Premiums may be estimated by looking at the rating
assigned to a country’s dollar-denominated sovereign debt.
 One can then look at the spread over US Treasuries or a
long-term eurodollar rate for countries with such ratings
(sovereign risk premium). This spread would be a measure
of the country risk premium.
 One could also look at the spread for US firms’ debt with
comparable ratings.
 Optionally, one might then adjust this spread by the ratio of
the standard deviation of equity returns in that country to the
standard deviation of bond returns – to convert a bond
premium to an equity premium.
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Using the Country Premium
 The country risk premium that is obtained can then be used
in two ways:


One, it could be added to the cost of equity of the project.
This assumes that the country risk premium applies fully to all
projects in that country
Two, one could assume that the exposure of a project to the
country risk is proportional to its beta. In this case, one would
add the country risk premium to the US market risk premium
to get an overall risk premium. This would then be multiplied
by the beta as before to obtain the project-specific risk
premium.
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Using the Country Risk Premium
 Finally, one could take the US market risk premium
and multiply it by the ratio of the volatility of stock
returns in the foreign country to the volatility of
stock returns in the US.
 This is the country-risk adjusted market risk
premium.
 As before, then, this market risk premium would be
multiplied by the beta of the project to get the
project-specific risk premium.
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Adjusting for Country Risk
 Suppose the market risk premium in US markets is
5.5%
 The yield on US 10 year treasuries is 5%
 The yield on German government bonds is 6%
 The world nominal risk-free rate (computed as the
lowest risk-free rate that can be obtained globally,
for borrowing in dollars – or otherwise adjusted for
exchange rate risk) is also assumed to be 5%.
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Adjusting for Country Risk
 Project beta with respect to US market is 1.0
 Project beta with respect to an international equity index is
1.1
 The beta of the German market with respect to the US
market portfolio is 1.2.
 The volatility of returns (std devn) on a broad-based US
market index is 25% per year.
 The volatility of returns on a broad-based German index is
35% per year.
 The volatility of returns on a broad-based world index is
30% (returns measured in dollars)
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Adjusting for Country Risk
 Reqd. ROR = US Riskfree rate + i(Market Risk Premium)
 If the investors in the project are investors who hold
domestic (US) diversified portfolios, then we use US
quantities. Suppose country risk is diversifiable or can
otherwise be ignored:

Reqd ROR = 5% + 1 (5.5) = 10.5%, and country risk premium is set
at zero.
 If the investors are internationally diversified, and country
risk can be ignored,

Reqd ROR = 5% + 1.1 (5.5) = 11.05%, and country risk premium is
set at zero.
 If we take a weighted average of the two rates (in this
example, we use 65-35 weights), we get 0.65(10.5) + (0.
35)(11.05) = 10.6925%
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Adjusting for Country Risk
 If we believe that country risk is not diversifiable and/or is
not otherwise captured in the beta computation or that it
captures other kinds of risk that go beyond variability risk,
we need to adjust for country risk.
 Add sovereign risk premium to the required rate of return:
(If we are worrying about country risk premiums, we’re
probably discounting the existence of a single international
asset pricing model, since it implies an integrated world.)
 In this case, the risk-free rate in Germany is 8%, which is
greater than the US 10 year treasury yield of 5% by 100 bp.
 This gives us a cost of equity capital of

5% + (6 - 5) + 1(5.5) = 11.5%
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Adjusting for Country Risk
 If we assume that the country risk premium is shared by the
project only to the extent that it moves with the market, then
we’d get

Required ROR = 5% + 1(5.5 + 1) = 11.5% (in this case, the rate
doesn’t change from the approach above, since the beta is 1).
 If we say that the country risk premium is shared by the
project only to the extent that it moves with its local market:

Reqd ROR = 5% + 1 (5.5) + (1.2)(1) = 14.1%, where the 1.2 is the
beta of the German market w.r.t. the US market portfolio.
 Amplifying CAPM beta by volatility ratio:


Amplified beta = 1x(35/30)
Hence the required rate of return is = 5% + 1(35/30)(5.5) = 11.42%
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Computing cost of debt on foreigncurrency loans
 Suppose Alpha S.A., a French subsidiary of a US firm
borrows €10m. for 1 year at an interest rate of 7%. If the
current rate is $0.87/€, this would be a $8.7m. loan.
 If the end-of-year rate is expected to be $0.85/€, the dollar
cost of the loan is only 4.54%, since (10.7)(0.85)/8.7 =
1.0454.
 In general, the dollar cost of a foreign currency loan with an
interest rate of rL and a depreciation of the home currency of
c% per year is given by rL(1 + c) + c.
 If the loan is taken by a foreign subsidiary and the interest
can be deducted for tax purposes, where the tax rate is ta,
then the effective dollar rate is r = rL(1+c)(1-ta) + c.
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The Cost of Debt Capital
 In general, the effective dollar interest rate is, r, where:



c is the annual rate of appreciation of the local currency
rL is the coupon rate of the loan
ta is the affiliate’s marginal tax rate
rL (1  c) i (1  t a ) (1  c) n
1 

0
i
n
(1  r )
(1  r )
i 1
n
 However, the solution to this general problem is the
same as the solution to the single period problem.
 Finally, we put the cost of debt and the cost of equity
together to get the WACC.
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Problem: Cost of debt capital
 IBM is considering having its German affiliate
issue a 10-year $100m. bond denominated in euros
and priced to yield 7.5%. Alternatively, IBM’s
German unit can issue a dollar-denominated bond
of the same size and maturity and carrying an
interest rate of 6.7%.
 If the euro is forecast to depreciate by 1.7%
annually, what is the expected dollar cost of the
euro-denominated bond? How does this compare to
the cost of the dollar bond?
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Problem: Cost of debt capital
 The pre-tax $ cost of borrowing in euros at a interest rate of
rL, if the euro is expected to depreciate against the dollar at
an annual rate of c, is rL(1 + c) + c. There is a “depreciation
penalty applied to the interest (first term) and to the
principal (second term).
 In this case, we get an expected $ cost of borrowing euros of
7.5(1-0.017)-1.7 or 5.67. This is below the 6.7% cost of
borrowing $s.
 If the German unit is taxed at ta, the ta, is r = rL(1+c)(1-ta) +
c. Thus, if ta = 35%, r = 7.5(1-0.017)(1-0.35) - 0.017, or
4.78%.
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Differentials in Cost of Funds for
foreign projects
 What if funds are available to finance foreign projects at
below-market costs?
 Suppose a foreign subsidiary requires $I of new financing
for a project as follows: $P from the parent, $Ef from the
subsidiary’s retained earnings, $Df from foreign debt.
 Suppose the cost of retained earnings for the subsidiary is ks
versus the general cost of equity for the parent, ke, and that
the cost of debt financing after-tax for the subsidiary is if
versus the after-tax cost of debt for the parent of id(1-t).
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Cost of foreign project
 Then the total cost of financing the project in
dollars is:

IkI = Iko - Ef (ke - ks) - Df[id(1-t) - if]
 Simplifying, we find that the WACC for the new
project, kI equals:


kI = ko - a (ke - ks) - b[id(1-t) - if]
where
ko= cost of capital of the parent
ks = cost of retained earnings for the subsidiary
if = the after-tax cost of foreign debt
a = Ef/I
b = Df/I
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