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Global Investments: Discover Your Real

Cost of Capital—and Your Real Risk

Otto B. Martinson

O
ver the past 20 approach. It can
years, changes A company can execute its global strategy by involve any part of the
in the structure internal diversification or by acquisitions. Either firm’s value chain,
of the international way, it will face some capital investment deci- including suppliers,
economy have pre- sions. But how do you pinpoint the real cost of buyers, and the chan-
sented new opportu- capital for a foreign investment—especially in a nels connecting them.2
nities to businesses risky country? The author offers some practical Most global strategies
looking to enter the guidance. ©2000 John Wiley & Sons, Inc.
usually involve an inte-
global marketplace. grated combination of
At the same time the trade and direct invest-
inventiveness of corporate man- ADOPTING A GLOBAL ment in foreign countries.
agement, including prompt STRATEGY
developments in product inno-
vation and manufacturing tech- The stage for global compe- UNDERSTANDING EVALUATION
nology, have enabled the more tition is set when some compa- METHODS
aggressive multinational com- nies gain advantages in their
panies to take advantage of home market that allow them to Whether a company chooses
these opportunities. In 1999, penetrate foreign markets. When to execute its global strategy by
U.S. companies increased their a company moves into the glob- way of internal diversification or
direct foreign investments by al market, it should be seeking acquisitions, it will be faced
28 percent.1 Of course, the to increase its competitive with some capital investment
pressure on profits at home, advantage by increasing its decisions.
and vulnerability of exports to competitive scope. Achieving Usually the investment deci-
indigenous competition, have these advantages will ultimately sion-making process will involve
also attracted companies to the require a more global approach the seven steps outlined in
growth opportunities in the for- to strategy. This means selling Exhibit 1. This process will be
eign markets. As companies worldwide, and involves locat- the same whether the investment
move to take advantages of ing activities in other nations in is being made for a domestic or
these opportunities, they will order to capture local advan- foreign project. Although the
need to develop an appropriate tages and to facilitate local mar- basic principles of analysis and
strategy, prepare a well-defined ket penetration. To achieve the methods of evaluation are
plan of action and be prepared strategic objectives may require similar, the cash flow analysis
to commit the resources a new product design, produc- for a direct foreign investment
required to implement it. tion process, or marketing project is much more complex

© 2000 John Wiley & Sons, Inc. 23

24 The Journal of Corporate Accounting & Finance

ment. To compute the pay-

Exhibit 1 back period, the initial invest-
ment is divided by the annual
Capital Investment Process cash flow. Payback provides
assistance in evaluating a
project’s risk and liquidity.
• Determine that the project meets the firm’s strategic objectives When the commitment is
• Compute the costs and revenues/benefits of the project short term there is less possi-
• Assess the risk associated with the project bility of loss from changes in
• Determine the cost of capital to be used in the evaluation economic conditions and
• Conduct the evaluation analysis
other unavoidable risks. A
major criticism of the
• Select or reject the project
Payback method is that it
• Perform a follow-up evaluation and tracking on selected project does not consider the time
value of money by using
present values.
than that for a domestic invest- ment project to the present value Supporters of Payback point
ment project. For example, in of the initial cash outlay for the out that it is a good tool for
evaluating an investment in a investment. Thus the Net Present screening projects where a poor
foreign subsidiary there are two Value of a project is the differ- credit position is a major factor
different relevant cash flows that ence in the present value of the or when investment funds are
need to be considered: (1) the forecasted cash inflows and the very scarce. The method would
cash flows generated by the present value of the expected be very useful in unstable situa-
investment/project and (2) the cash outlay required for the tions or when there is consider-
resulting cash flows available to investment. able uncertainty as may be
the parent company in the form To compute the present encountered in foreign invest-
of dividends and/or royalties that value of these cash flows, a dis- ment projects. In such situations,
can be repatriated from the sub- count rate must be developed. where the future is so unpre-
sidiary. The discount rate used is nor- dictable, the principal objective
There are a number of dif- mally viewed as the “cost of may be to minimize the risk by
ferent methods used to assess the capital.” Then based on the selecting projects that have the
value-enhancing potential of number of years involved in the shortest payback period.
capital investment opportunities. project and the discount rate Companies faced with the need
Most of these methods employ used, appropriate discount fac- to make investments in some
some form of discounted cash tors are obtained from Present unstable foreign country will
flow analysis. The most preva- Value tables. These discount fac- find this method of evaluation
lent analytical method used for tors are then applied to the useful in rank ordering the alter-
this type of analysis is the Net applicable cash outflows and natives. For example, they could
Present Value (NPV) method. inflows, thereby reducing the establish a threshold, say a three-
There is also a method, used for outflows and inflows to their year payback, and not accept any
many years, which reflects sensi- present value. Then the present project that exceeds it.
tivity to time by measuring how value of the cash outflow is sub-
long it takes to recover the tracted from the cash inflow to
investment. This method is arrive at the Net Present Value. DISCOUNT RATE/ COST OF
known as the Payback Period. If the project has a positive Net CAPITAL
Both of these methods are Present Value, it would be con-
described below. sidered acceptable. The most important step in
the above analytical process is
the development of the discount
Net Present Value Payback Period rate/cost of capital. The appro-
priate cost of capital for a capital
The NPV method compares This method of analysis investment project, whether it is
the present value of future cash determines the number of years domestic or foreign based, is a
flows expected from the invest- it takes to recover your invest- function of the perceived risk of

© 2000 John Wiley & Sons, Inc.

September/October 2000
the investment. For those invest-
ments in the United States, the
procedure for developing an
appropriate discount rate is well
defined. You apply the concepts
of the weighted average cost of
capital (WACC) and use the cap-
ital asset pricing model (CAPM)
for computing the cost of equity
capital component. The CAPM
is based on the premise that an
industry’s cost of capital
includes a risk free rate plus an
equity premium for risk. The
risk free rate (RF) is equal to the
long-term government bond rate.
The premium for risk (RP) is the
difference between (a) the return
earned by investors in a particu-
lar industry and (b) the average
return earned by investors in the
market as a whole. Then a “beta”
is developed which relates a spe-
cific industry’s risk to the aver-
age market risk. This yields what
is called the beta coefficient (b)
for risk. Thus cost of equity
(CE) is CE = RF + b(RP). A
useful source for these rates and
the beta’s is Ibbotson’s
3
Cost of
Capital Quarterly.
To illustrate with some num-
bers, assume ACORP has a capi-
tal structure of 40 percent debt
and 60 percent equity,
with a tax rate of 36
percent. The risk free Exhibit 3
rate (RF) is 6.7 per-
cent, the beta (b) is
1.3, and the risk pre-
mium (RP) is 8 per-
cent. The unadjusted
WACC for U.S. proj-
ects by ACORP would
be 12 percent as calcu-
lated in Exhibit 2.
• International Country Risk Guide, published by a U.S. division of
ADJUSTMENTS TO
COST OF CAPITAL
• Country Forecasts is published by Political Risk Services (Syracuse, NY). It
Having developed
the WACC for use in
U.S. projects, it will
© 2000 John Wiley & Sons, Inc.
25
be necessary to
adjust this rate Exhibit 2
for the addi-
tional risk inher- WACC (Unadjusted) for ACORP
ent in foreign-
based projects. Cost of Debt + Cost of Equity
This additional .40 [RF x (1-.36)] + .60 [RF + b (RP)]
risk is a function .40 [6.7 x .64] + .60 [6.7 + 1.3 (8)]
of these coun- .40 [ 4.28] + 60 [17.1]
try-specific fac- 1.72 + 10.26
tors: political = 11.98%
risk, interest rate rounded = 12%
differential, and
tax rate differ-
ences.4 How one
should analyze these risks is often used as the standard
described below. benchmark against which politi-
cal risk is measured. Some inde-
pendent services that provide
Political Risk political risk and country ratings
are presented in Exhibit 3.
Measures for this would To provide a framework for
include such things as the fre- quantifying political risk, one
quency of government changes, could assign a judgment-based
amount of violence in the coun- 300 basis points for every grade
try, number of armed insurrec- difference in the “investment”
tions, and conflicts with other category. For example, if the
countries. Other important indi- United States is rated A and the
cators of political risk include subject country is C, an incre-
issues such as inflation, balance mental risk premium of 600
of payments deficits/surpluses, points would be added to the
and the level and growth rate of cost of capital. Where the rating
per capita gross national product system includes a “+” and “-”,
(GNP). Country risk surveys are these can be assigned 100 basis
Who Rates Political Risk?
• Euromoney magazine issues an annual Country Risk Rating. It is based on
a measure of different countries’ access to international credit and pay-
ment record.
• Economist Intelligent Unit is a New York-based subsidiary of the Economist
Group. This rating is based on such factors as external debt, foreign-
exchange reserves, and consistency of government policy.
International Business Communications, Ltd. (London), offers a composite
risk rating, along with individual ratings for political, financial, and econom-
ic risk.
provides semiannual country forecasts.
26 The Journal of Corporate Accounting & Finance

points. Thus, if there is a differ-

ence between A and B- in the Exhibit 4
rating, the risk premium would
be 400 basis points.
Examples of Rates for Emerging Market Bonds
Interest Rate Differential
Coupon S&P Bond Spread
This measurement provides Rate Rating Yield vs. U.S.
an indication of the general eco-
nomic condition of a country Latin America
and is directly related to infla- Argentina 9.750 BB 13.25 + 7.92
tion. It represents another Brazil 10.125 BB- 16.43 +11.10
important element of risk. Mexico 11.500 BB 12.47 + 7.25
Developed countries usually
have inflation rates in the low to Asia
middle single digits—whereas China 7.750 BBB+ 9.11 +4.80
developing or emerging coun- Philippines 8.750 BB+ 13.42 +8.24
tries have inflation rates that are
Thailand 7.750 BBB+ 12.92 +7.87
in the range of high single digits
to double digits—and in some
cases, even higher (hyperinfla- Africa/Middle East
tion). According to Country Lebanon 9.125 BB- 8.73 +3.79
Forecasts, for the period 1998— South Africa 8.375 BB+ 9.50 +4.47
2002, Argentina’s inflation rate Turkey 10.000 B 12.98 +7.93
is estimated to be 1.8 percent
per annum compared to Chile’s
estimated 6 percent. Of course,
low inflation does not always very useful source is the Web tax savings on the cost of debt
indicate economic stability. site for the Brady Bonds— that the company includes in its
Even with low inflation, www.bradybonds.com. Brady cost of capital calculation for the
Argentina has a high probability Bonds were created to help specific investment. One can
of turmoil. For example, developing nations restructure usually obtain the tax rates for
Country Forecasts gives defaulted or devalued commer- various countries from any of the
Argentina an average of B for cial bank debt in the 1980s. To national or regional public
transfer, investment, and export illustrate the variations in inter- accounting firms. They likely
factors, whereas the United est rates among emerging coun- will be able to provide a world-
States and most developed coun- tries, some examples of bond wide corporate income tax sum-
tries are given an A rating. rates are presented in Exhibit 4. mary. It should be noted that
There are a number of good Please note that these rates are some countries have regional tax
sources for obtaining interest not current. rates and others use surcharges
rates by country. One popular as well.
source is the Economist, which
includes bond rates for devel- Income Tax Rate Differences
oped countries and short-term DEVELOPMENT OF GLOBAL
interest rates for developing The third factor to consider COST OF CAPITAL RATE
countries. Another source for is the differences in the income
interest rates yield spreads to tax rates between the foreign Having developed the
U.S. Treasuries is the Financial country and the United States. weighted average cost of capital
Times, which includes ten-year This measurement of the tax dif- for ACORP as described above
benchmark spreads of develop- ferential reflects an actual differ- in Exhibit 2, the next step is to
ing countries and emerging mar- ence in the after tax cost of cor- adjust the cost of capital to
ket spreads. On the Internet, a porate debt. It affects the income include a premium for the three

© 2000 John Wiley & Sons, Inc.

September/October 2000 27

factors outlined above: country-

specific income tax rate, interest Example 2
rate difference, and the political Cost of Debt Cost of Equity
risk adjustment factor. A two- United States 6.7 17.1
step approach can be used to Add rate premium 4.9 4.9
make these adjustments:5 Adjusted rate 11.6 22.0

1. Adjust U.S. WACC for coun- Example 3

try income tax rate and then
add political risk
factor if applicable.
2. Adjust U.S. WACC for coun-
try income tax rate and then
add interest rate yield differ-
ential to U.S. rate.
To illustrate the methodolo-
gy, the cost of capital for
ACORP will be developed for
evaluating a project to be imple-
Example 1
Country-specific income tax rate impact = % debt [RF x (1-.34) + Cost of Equity
Add political risk premium
Cost of Capital (step 1)
mented in Mexico. Using
Country Forecasts published by
Political Risk Services (PRS)
shows that Mexico, in terms of
political risk, was rated B- and
the United States was given an
A rating. This is based on 12
rating grades ranging from A+
to D-. To quantify the analysis, a
numeric ranking is assigned
each grade, with number 12
assigned to A+ and 1 to a D-
grade. Using this ranking
method, there was a difference
of four grades, with the United
States ranked eleventh and
Mexico seventh. Applying 100
basis points to each grade, the
increased risk of turmoil and
higher investment risk were
WACC (with rate premium) = % debt [RF x (1-.34) + Cost of Equity
= .40 [11.6 x .66] + .60 (22.0)
= 4.64 + 13.2
Cost of Capital (step 2) = 17.84%
assigned a 400 basis point risk Mexico’s bond rate was 490
premium. basis points higher than the U.S.
As for the income tax differ- bond rate. When this premium is
ential applicable to ACORP, the added to the cost of debt and
Mexico income tax rate, at 34 cost of equity, the result can be
seen in Example 2.
Using these adjusted rates
for the Cost of Debt and Cost of
Equity, with the rate premium
added, the resulting WACC is
= .40 [6.7 x .66] + 10.26 seen in Example 3.
= 1.77 + 10.26 By combining the results of
= 12.03% steps 1 and 2, a weighted cost of
4.00% capital can be computed using
= 16.03% the premium adjusted cost of
capital rates. Exhibit 5 shows
that the result of step 1 is given
the highest weight (70 percent),
percent, was lower than that of whereas the step 2 result was
the United States. Using this assigned a 30 percent weight.
lower tax rate to compute step 1 The lower rating for step 2
described above, the cost of debt reflects that most of the political
is 16.03 per-
cent. As seen
in Example 1. Exhibit 5
To factor
in the interest
rate differen- Weighted WACC from Steps 1 and 2
tial for step 2,
the interest WACC
rate yield on Method Weight WACC Weighted
U.S. and
Step 1 .70 16.03 11.22
Mexico long-
Step 2 .30 17.84 5.35
term govern-
ment bonds
were com- Premium Adjusted Cost of Capital 16.57 or 17%
pared. This
indicated that

© 2000 John Wiley & Sons, Inc.

28 The Journal of Corporate Accounting & Finance

risk is already accounted for in
the country-specific yield struc-
ture used in step 1.
As companies continue to
seek ways to strengthen their
competitive advantage, they will
be faced with the need to com-
bine the advantages they have at
their home base with those that
result from a presence in other
countries, such as the ability to
serve a new market and transfer
their brand reputation.
A recent study by the World
Economic Forum and Deloitte
Touche Tohmatsu measured the
impact of globalization on cor-
porate enterprise value. The
study showed that 84 percent of
the companies that ranked high
for globalization have outper-
formed the S&P 500 over the
past five years. Faced with
maturing markets in the United
States, a growing number of
firms are looking for opportuni-
ties in less developed countries
where the rate of economic
growth is 5 percent to 7 percent
a year. As companies move into
these less developed countries,
they will have to contend with
more political risk and financial
instability.
To address these problems
and assess the capital invest-
ment projects associated with
this global expansion, it will be
essential that companies estab-
lish a proper cost of capital for
evaluating these global invest-
ment opportunities. The
methodology outlined above for
establishing the cost of capital
for foreign investments should
be helpful in making these eval-
uations.
NOTES
1. U.S. Department of Commerce. (2000,
March). Survey of current business,
80(3).
2. Porter, M.E. (1990).The competitive
advantage of nations. New York: The
Free Press.
3. Visit the Web site at www.ibbotsons.com.
4. Reilly, R.F., & Schweihs, R.P. (2000).
Handbook of advanced business valua-
tion. New York: McGraw-Hill.
5. This methodology was developed in
Chapter 2 of the Handbook of
Advanced Business Valuation (see
note 4).

Otto B. Martinson, CMA, CFM, CPA, Ph.D., is a professor in the Department of Accounting at Old Dominion
University, Norfolk, Virginia. Prior to joining Old Dominion University he was vice president of strategic plan-
ning for the Carlson Companies, Inc., a multi-billion dollar company in Minneapolis. Dr. Martinson was
recently elected national vice president for the Institute of Management Accountants where he serves as
a trustee on the Foundation for Applied Research, and is a member of the Committee on Cost Accounting
Standards.

© 2000 John Wiley & Sons, Inc.