International Cost of Capital or chapter 11 Agenda

International Cost of Capital (or chapter 11)

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

Weighted Average Cost of Capital k. WACC = weighted average cost of capital, WACC ke = risk adjusted cost of equity kd = before-tax cost of debt t = tax rate E = market value of equity D = market value of debt V = market value of firm (D+E)

International Cost of Equity How to estimate? Many approaches: • World CAPM (W. Sharpe). • Segmented/Integrated CAPM (G. Bekaert & C. Harvey). • Goldman Sachs - integrated. • A. Damodaran’s method.

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

World CAPM Failure Wrong risk / return relation !! Source: Cam Harvey’s web site @ http: //www. fuqua. duke. edu 6

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

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

Equity Risk Premium Source: Ibbotson Associates

Source: Ibbotson Associates

Cost of Equity & Debt: CAPM example § Cost of equity: calculate using Capital Asset Pricing Model (CAPM) Where § ke = expected rate of return on equity krf = risk free rate on bonds km = expected rate of return on market β = coefficient of firm’s systematic risk Cost of debt: analyze proportions of various debt & their associated interest rates & calculate before- & after-tax weighted average cost of debt.

CAPM example § A company headquartered in US § Use US as base for market & equity risk calculation k. WACC = weighted average cost of capital ke = Cost of equity is 17% kd = Before-tax cost of debt is 8% t = tax rate of 35% E/V = equity-to-value ratio 60% D/V = debt-to-value ratio 40%

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

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

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

Is MNE WACC < domestic WACC? Theory: MNE should have low cost & abundant capital. Marginal cost of capital (%) Large MCCDC Small Set of Projects 20% MCCMNE 15% 10% MRRMNE 5% MRRDC 100 140 300 350 400 Budget ($m)

But…a few unsettling facts… MNEWACC >? < Domestic. WACC k. WACC = ke [ Equity Value ] + kd ( 1 – tax ) [ Debt Value ] MNE: lower debt/capital ratio => higher cost capital. MNE: lower cost of debt => lower cost capital. • Required cost of equity higher for MNE (Political risk, forex risk, high agency costs). • => At high levels of capital budget, MNE has lower cost of capital.

Things to remember… § Weighted average cost of capital? § How to find international cost of equity? § Market liquidity/segmentation & cost of capital? § MNE vs. domestic WACC?