Multinational Financial Management Alan Shapiro 7th Edition J. Wiley & Sons Power Points by



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Multinational Financial Management Alan Shapiro 7th Edition J.Wiley & Sons

  • Power Points by

  • Joseph F. Greco, Ph.D.

  • California State University, Fullerton


CHAPTER 14

  • THE COST OF CAPITAL FOR FOREIGN INVESTMENTS



CHAPTER OVERVIEW:



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



THE COST OF EQUITY CAPITAL

  • B. Capital Asset Pricing Model

  • ri = rf + i ( rm - rf )

  • where ri = the equity required rate

  • rf = the risk free return rate

  • i= Cov(rm, ri)/ 2 rm where



THE COST OF EQUITY CAPITAL

  • Cov(rm, ri) is the covariance between asset and market returns and 2 rm , the variance of market returns.



II. THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS

  • II. FOREIGN PROJECTS

  • A. Weighted Average Cost of Capital (WACC = k0)

  • k0 = (1-L) ke + L id (1 - t)

  • where L = the parent’s debt ratio

  • id (1 - t) = the after-tax debt cost

  • ke = the equity cost of capital



THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS

  • k0 is used as the discount rate in the

  • calculation of Net Present Value.

  • 2. Two Caveats

  • a. Weights must be a proportion using

  • market, not book value.

  • b. Calculating WACC, weights must be

  • marginal reflecting future debt

  • structure.



III. DISCOUNT RATES FOR FOREIGN INVESTMENTS

  • III. DISCOUNT RATES AND FOREIGN PROJECTS

  • A. Systematic Risk

  • 1. Not diversifiable

  • 2. Foreign projects in non-synchronous economies should be less correlated with domestic markets.



DISCOUNT RATES FOR FOREIGN INVESTMENTS

  • 3. Paradox: LDCs have greater political

  • risk but offer higher probability of

  • diversification benefits.



DISCOUNT RATES FOR FOREIGN INVESTMENTS

  • B. Key Issues in Estimating Foreign Project Betas

  • -find firms publicly traded that share

  • similar risk characteristics

  • -use the average beta as a proxy



DISCOUNT RATES FOR FOREIGN INVESTMENTS

  • 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?



DISCOUNT RATES FOR FOREIGN INVESTMENTS

  • 2. Proxy Companies

  • a. Most desirable to use local firms

  • b. Alternative:

  • find a proxy industry in the local market



DISCOUNT RATES FOR FOREIGN INVESTMENTS

  • 3. Relevant Base (Market) Portfolio

  • a. If capital markets are globally

  • integrated, choose world mkt.

  • b. If not, domestic portfolio is best



DISCOUNT RATES FOR FOREIGN INVESTMENTS

  • 4. Relevant Market Risk Premium

  • a. Use the U.S. portfolio

  • b. Foreign project: should have

  • no higher than domestic risk

  • and cost of capital.



IV. THE COST OF DEBT CAPITAL

  • The use of sovereign risk premium is appropriate for estimating the cost of debt associated with a foreign project.



V. ESTABLISHING AWORLD WIDE CAPITAL STRUCTURE

  • V. MNC ADVANTAGE IN ESTABLISHING A WORLDWIDE CAPITAL STRUCTURE:

  • It uses more debt due to diversification



ESTABLISHING A WORLD WIDE CAPITAL STRUCTURE

  • A. 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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