Unit 7

Global Cost of Capital and Capital

Structure

Sanjay Ghimire
TU-SoM
1
 Contents

– Weighted average cost of capital;

– Demand for foreign securities cost of capital for
MNCs compared to domestic firms;
– Sourcing equity and debt globally

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Weighted Average Cost of Capital
● A firm normally finds its weighted average cost of capital (WACC)
by combining the cost of equity with the cost of debt in proportion to
the relative weight of each in the firm’s optimal long-term capital
structure:

kWACC = weighted average after-tax cost of capital

ke = cost of equity (expected (required) rate of return on equity)
kd = before-tax cost of debt
t = corporate tax rate
E = market value of the firm’s equity
D = market value of the firm’s debt
V = total market value of 14-3
the firm’s securities (=D+E)
Weighted Average Cost of Capital

● The capital asset pricing model (CAPM) approach is to

define the cost of equity for a firm by the following
formula:

ke = expected (required) rate of return on equity

krf = rate of interest on risk-free bonds (Treasury bills, for example)
km = expected (required) rate of return on the market portfolio of
stocks
βj = coefficient of systematic risk for the firm ( )
ρjm = correlation between returns of security j and the market
σj = standard deviation of the return on firm j
σm = standard deviation of the market return
Weighted Average Cost of Capital

● Beta will have a value of less than 1.0 if the firms’ returns
are less volatile than the market, equal to 1.0 if the same
as the market, or greater than 1.0 if more volatile (risky)
than the market
● CAPM assumes that the estimated expected return, ke,
is a hurdle rate to keep an investor’s capital invested in
the equity (so ke is also called the required rate of return)
● If the equity’s expected return does not reach the
required return, CAPM assumes that individual investors
will liquidate their holdings
Weighted Average Cost of Capital

● The normal procedure for measuring the cost of debt

requires a forecast of (1) interest rates for the next few
years, (2) the proportions of various classes of debt the
firm expects to use, and (3) the corporate income tax
rate
● The interest costs of different debt components are then
averaged (according to their proportion)
● The before-tax average, kd, is then adjusted for
corporate income taxes by multiplying it with the
expression (1- tax rate), to obtain kd(1-t), the weighted
average after-tax cost of debt
Example of Calculating WACC
Weighted Average Cost of Capital

● The weighted average cost of capital (WACC) is

normally used as the risk-adjusted discount rate for
the future operating cash flows of a firm and thus
estimating the net present value of a firm
● When a firm’s new projects are in the same general risk
class as its existing business, WACC is used as the
discount rate for the new project
● On the other hand, a project-specific required rate of
return (rather than the WACC) should be used as the
discount rate if a new project differs from existing
business of the firm in various risk level
Weighted Average Cost of Capital
● An internationalized version of CAPM will have a different
definition of the market portfolio and a recalculation of the firm’s
beta for that market portfolio
● So, the internationalized version of CAPM could generate a
different estimation from that of the domestic version of CAPM
The Demand for Foreign Securities:
The Role of International Portfolio Investors

● Gradual deregulation and integration of equity markets

during the past three decades not only elicited increased
competition from domestic players but also opened up
markets to foreign competitors
● To understand the motivation of portfolio investors to
purchase and hold foreign securities requires an
understanding of the principals of (1) portfolio risk
reduction, (2) portfolio rate of return, and (3) foreign
currency risk .
The Demand for Foreign Securities:
The Role of International Portfolio Investors

● Both domestic and international portfolio managers are

asset allocators whose objective is to maximize a
portfolio’s rate of return for a given level of risk, or to
minimize risk for a given rate of return
● Portfolio asset allocation can be accomplished along
many dimensions by, e.g. types of securities (stocks or
bonds), industries (food or electronic), size of
capitalization (small-cap or large-cap), countries (Korea
or Taiwan), geographic region (Asian or Europe), stage
of development (industrialized or emerging countries)
The Demand for Foreign Securities:
The Role of International Portfolio Investors

● Since international portfolio managers can choose from

a larger bundle of assets than domestic portfolio
managers, internationally diversified portfolios often
have a higher expected rate of return, and nearly
always have a lower level of portfolio risk since
national securities markets are imperfectly correlated
with one another
The Demand for Foreign Securities:
The Role of International Portfolio Investors

● Market liquidity
– Here we study the market liquidity by observing the degree to
which a firm can issue a new security without depressing the
existing market price (the depression of the market price implies
the increase of the marginal cost of capital of issuing new
security)
– Suppose firms always expand their capital budgets at their
optimal capital structures, i.e. the financial risk of firms does not
change with the expansion
– Even so, market liquidity still can affect a firm’s marginal cost of
capital
The Demand for Foreign Securities:
The Role of International Portfolio Investors

● In the domestic case, eventually the firm needs to increase

its capital budget to the point where its marginal cost of
capital is increasing because the domestic capital market
become saturated
● In the multinational case, a firm is able to tap many foreign
capital markets and raises funds over what would have
been available in a domestic capital market only
– Escaping from an illiquid market, a firm could
access more sources of capital, so it could raise
more funds without increasing its marginal cost of
capital
The Demand for Foreign Securities:
The Role of International Portfolio Investors

● Market segmentation
– Capital market segmentation is caused mainly by many market
imperfections
– In a segmented market, since there is no foreign participants, the
securities would be priced on the basis of domestic rather
than international standards
– the internationalized version of CAPM employed by international
investors could generate a lower estimation for the firm’s cost of
equity and thus a higher market value of the equity of the firm
– In a word, escaping from a segmented market, a firm could have
a better price for its securities and thus a lower cost of
capital based on international rather than domestic standards
 The Demand for Foreign Securities:
The Role of International Portfolio Investors

● The effect of market liquidity and segmentation

– If the firm is limited to raising funds in its domestic (illiquid)
market, even the capital structure being the same and the thus
financial risk remaining fixed, the MCC is is fixed at a rate for
small capital budget levels but finally increases with the increase
of the capital budget level
– If the firm has additional sources of capital outside the
domestic (illiquid or small) capital market, the marginal cost of
capital shifts right to MCCF
The Demand for Foreign Securities:
The Role of International Portfolio Investors

– This is because foreign markets can provide long-term funds at

times when the domestic market is saturated because of
heavy use by other borrowers or equity issuers. As a
consequence, given the same capital budge level for the firm, the
MCCF is lower than or equal to MCCD
– If the domestic capital market is both illiquid and segmented,
accessing the international capital market can bring both effects
of greater availability of capital and international pricing of
the firm’s securities
– Thus, MCCD becomes MCCU, which is lower and fixed at 10% for
small capital budget levels, and begins to increase when the
capital budget level is larger than about $50 million
 Market Liquidity,
Segmentation, and the
Marginal Cost of Capital
Marginal cost of
capital
and rate of
return
MCCF MCC
MCCD U

kD
20% kF
15% kU
13%
10% MRR

Capital Budget
1 2 3 4 5 6 (millions of $)
※The intersection of0MCC 0and MRR
D
0 indicates
0 0 the optimal
that 0 capital budget is $40
million and the marginal cost of capital is 20%
※The intersection of MCCF and MRR indicates that the firm can reduce its marginal
international cost of capital to 15% even while it raises an addition $10 million.
※The intersection of MCCU and MRR indicates that the marginal cost of capital declines
to 13% and the optimal budget climbs to $60 million
The Cost of Capital for MNEs
Compared to Domestic Firms

● Theoretically, the MNE is supposed to have a lower

marginal cost of capital (MCC) and thus a lower
weighted average cost of capital (WACC) than a
domestic firm, empirical studies show that it is usually
not the case, i.e. the MNE’s WACC is actually higher
than that for a comparable domestic firm
● Determining whether a firm’s cost of capital is higher or
lower than a domestic counterpart is a function of the
marginal cost of capital, the optimal debt ratio, the
relative cost of debt, and the relative cost of equity
The Cost of Capital for MNEs
Compared to Domestic Firms

● In conclusion, if both MNEs and domestic firms do

actually limit their capital budgets to what can be
financed without increasing their MCC, then it is
consistent with empirical findings that MNEs have higher
WACC stands
● If the domestic firm has such good growth opportunities
that it chooses to undertake growth despite the
increasing marginal cost of capital, then the MNE would
have a lower WACC
The Cost of Capital
for MNE & Domestic Counterpart Compared

Marginal cost of capital

and rate of return
(percentage) MCCDC

20%

15% MCCMNE

10%

5% MRRMNE
MRRDC
Capital
100 140 300 350 400 Budget
(millions of
$)
The Cost of Capital for MNEs
Compared to Domestic Firms
● Regarding the optimal debt ratio
– Because a MNE’s cash flows are diversified internationally, the
variability of its cash flows is minimized and its ability to serve the
debt is enhanced
– Theoretically, MNEs could adopt higher debt ratios, but the
empirical studies have opposite conclusion: due to the higher
agency costs, political risk, foreign exchange risk, and
asymmetric information, MNEs have lower debt ratios
● Regarding the relative cost of debt
– Through financing globally, it is generally true that MNEs can find
debt funds with lower cost of debt
– However, for your information, despite the favorable effect of
international diversification of cash flows, bankruptcy risk was
about the same for MNEs as for domestic firms