Global Cost & Availability of Capital - NYU Stern School of ...

Global Cost & Availability of Capital - NYU Stern School of ...

International Cost of Capital (or chapter 11) 1 Agenda Weighted average cost of capital? How to find international cost of equity? Market liquidity/segmentation & cost of capital? MNE vs. domestic counterpart WACC? 2 Weighted Average Cost of Capital k WACC E D k e k d (1 t) V V kWACC = 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) 3 International Cost of Equity

How to estimate? Many approaches: World CAPM (W. Sharpe). Segmented/Integrated CAPM (G. Bekaert & C. Harvey). Goldman Sachs - integrated. A.Damodarans method. 4 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 + x world risk premium. Beta () measured relative to world portfolio. What is beta? jm j m 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 Returns & Beta, 1990 - 2002 Average Country returns

0.5 -0.5 0.4 0.3 0.2 0.1 0 -0.1 0 0.5 1 1.5 2 2.5 3 Beta

Wrong risk / return relation !! Source: Cam Harveys web site @ http://www.fuqua.duke.edu 6 Segmented/Integrated CAPM CAPM assumes perfect integration. Markets oftentimes arent! STEPS Estimate world beta & expected return = world CC = risk-free + W x world risk premium. Estimate local beta & expected return = local CC = local risk-free + L x local risk premium. Put two in common currency terms. 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 Estimate market beta on S&P 500. Get beta times historical US equity premium. Add sovereign yield spread plus risk free to get equity risk premium.

Useful if you have sovereign yield spread. Model used by McKinsey, 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 9 Source: Ibbotson Associates 10 Cost of Equity & Debt: CAPM example Cost of equity: calculate using Capital Asset Pricing Model (CAPM)

k e k rf (k m k rf ) Where ke = expected rate of return on equity krf = risk free rate on bonds km = expected rate of return on market = coefficient of firms systematic risk Cost of debt: analyze proportions of various debt & their associated interest rates & calculate before- & after-tax weighted average cost of debt.

11 CAPM example A company headquartered in US Use US as base for market & equity risk calculation kWACC = 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%

k WACC 17% 0.60 8% (1 0.35) 0.40 k WACC 12.28% 12 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 for forex & political risks. Caused by:

Asymmetric information High transaction costs Corporate governance practices Regulatory barriers 13 Liquidity/Segmentation & MCC* Marginal cost of capital & Marginal rate of return (%) MNE from illiquid & segmented market MNE from illiquid market Domestic MCCF MCCD kD

20% 15% 13% 10% kF MCCU kU MRR 10 * Marginal Cost of Capital 20 30 40 50

60 Budget ($million) 14 MNE vs. domestic WACC Empirical studies have found that: MNE has lower debt/equity ratio MNE has higher systematic risk! jm j m 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!!! 15 Is MNE WACC < domestic WACC? Theory: MNE should have low cost & abundant capital. Marginal cost of capital (%) Large MCCDC Small Set of Projects Set of Projects

20% MCCMNE 15% 10% MRRMNE 5% MRRDC 100 140 300 350 400 Budget ($m)

16 Buta few unsettling facts MNEWACC >?< DomesticWACC kWACC = 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. 17 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? 18

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