international capital structure and cost of capital

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INTERNATIONAL

FINANCIAL

MANAGEMENT

EUN / RESNICK

Fifth Edition

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


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Fifth Edition

Chapter Objective:This chapter discusses the cost of capital for the

multinational firm.

17Chapter SeventeenInternational Capital

Structure and the Costof Capital

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Cost of Capital

Cost of Capital in Segmented vs. Integrated Markets

Does the Cost of Capital Differ Among Countries?

Cross-Border Listings of Stocks

Capital Asset Pricing Under Cross-Listings

The Effect of Foreign Equity Ownership Restrictions

The Financial Structure of Subsidiaries.

Chapter Outline

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Weighted Average Cost of Capital

Where

K= weighted average cost of capital

Kl = cost of equity capital for a levered firm

i = pretax cost of debt

= debt to total market value ratio

t= marginal corporate income tax rate

K= (1)Kl + (1t)i

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The Firms Investment Decision and

the Cost of Capital

A firm that can reduce its

cost of capital will

increase the profitable

capital expenditures thatthe firm can take on and

increase the wealth of the

shareholders.

Internationalizing thefirms cost of capital is

one such policy.Investment ($)

Kglobal

Klocal

Ilocal Iglobal

IRR

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Cost of Capital in Segmented vs.Integrated Markets

The cost of equity capital (Ke) of a firm is the

expected return on the firms stock that investors

require.

This return is frequently estimated using the

Capital Asset Pricing Model (CAPM):

where bi=Cov(Ri ,RM)

Var(RM)

Ri =Rf+ bi(RMRf)

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Cost of Capital in Segmented vs.Integrated Markets

If capital markets are segmented, then investors can only

invest domestically. This means that the market portfolio

(M) in the CAPM formula would be the domestic portfolio

instead of the world portfolio.

versus

Clearly integration or segmentation of international financial

markets has major implications for determining the cost of

capital.

Ri =Rf+ bi (RU.S.Rf)U.S.

Ri =Rf+ bi (RWRf)

W

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Cross-border listings of stocks do carry costs.

1. It can be costly to meet the disclosure and listing

requirements imposed by the foreign exchange and

regulatory authorities.2. Once a companys stock is traded in overseas

markets, there can be volatility spillover from these

markets.

3. Once a companys stock is make available toforeigners, they might acquire a controlling interest

and challenge the domestic control of the company.

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On average, cross-border listings of stocks appears

to be a profitable decision.

The benefits outweigh the costs.

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Foreign Firms Listed on the NYSE (Selected)Japan Canon, Honda Motor, Japan Air Lines, Kubota,

Mizuho Financial, NTT Docomo, Sony, Toyota MotorKorea Korea Electric Power, Korea Telecom, Pohang Iron &

Steel, SK Telecom

Mexico Cemex, Empresas ICA, Grupo Televisa, Telefonos de

Mexico, Vitro

Netherlands Aegon, Arcelor Mittal, Royal Dutch Shell, Unilever,

ABN Amro Holdings, ING

Russia Mechel OAO, Rostelecom, Vimpel-Communications

South Africa ASA, Gold Fields, SasolSpain Banco Santander, BBVA, Repsol, Telefonica

United

Kingdom

Barclays, BP, Beazer, Cadbury Schweppes,

GlaxoSmithKlein, HSBC, Lloyds, Prudential, Royal Bank

of Scotland Vodafone17-15


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Capital Asset PricingUnder Cross-Listings

Recall the definition of beta:

We can recalibrate the CAPM formula

As:

bi=Cov(Ri ,RM)

Var(RM)

Ri =Rf+ bi(RMRf)

Ri =Rf+ (RMRf) Cov(Ri ,RM)

Var(RM)

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We can develop a measure of aggregate risk aversion,AM

We can restate the CAPM usingAM

Ri =Rf+ (RMRf) Cov(Ri ,RM)

Var(RM)

AMM =(RMRf)

Var(RM

)

Ri =Rf+AMMCov(Ri ,RM)

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C i l A P i i


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This equation indicates that, given investors aggregate risk-

aversion measure, the expected rate of return on an asset

increases as the assets covariance with the market

portfolio increases.

In fully integrated capital markets, each asset will be priced

according to the worldsystematic risk.

Ri =Rf+AMMCov(Ri ,RM)

Ri =Rf+AWWCov(Ri ,RW)

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C it l A t P i i


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The International Asset Pricing Model (IAPM) above has anumber of implications.

International listing of assets in otherwise segmented marketsdirectly integrates international capital markets by makingthese assets tradable.

Firms with nontradable assets essentially get a free ride from

firms with tradable assets in the sense that the formerindirectly benefit from international integration in terms ofa lower cost of capital.

Ri =Rf+AWWCov(Ri ,RW)

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Th Eff t f F i E it


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The Effect of Foreign EquityOwnership Restrictions

While companies have incentives to

internationalize their ownership structure to lower

the cost of capital and increase market share, they

may be concerned with the possible loss ofcorporate control to foreigners.

In some countries, there are legal restrictions on

the percentage of a firm that foreigners can own. These restrictions are imposed as a means of

ensuring domestic control of local firms.

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Pricing-to-Market Phenomenon

Suppose foreigners, if allowed, would like to buy30 percent of a Korean firm.

But they are constrained by ownership constraints

imposed on foreigners to purchase at most 20percent.

Because this constraint is effective in limitingdesired foreign ownership, foreign and domestic

investors many face different market share prices. This dual pricing is the pricing-to-market

phenomenon.

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Asset Pricing under Foreign Ownership

Restrictions

An interesting outcome is that the firms cost of

capital depends on which investors, domestic or

foreign, supply capital.

The implication is that a firm can reduce its costof capital by internationalizing its ownership

structure.

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A E l f F i O hi


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An Example of Foreign Ownership

Restrictions: Nestl

Following this, the price spread between the two types of

shares narrowed dramatically.

This implies that there was a major transfer of wealth from

foreign shareholders to Swiss shareholders.

The price of bearer shares declined about 25 percent.

The price of registered shares rose by about 35 percent.

Because registered shares represented about two-thirds of

the market capitalization, the total value of Nestlincreased substantially when it internationalized its

ownership structure.

Nestls cost of capital therefore declined.

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An Example of Foreign Ownership


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An Example of Foreign OwnershipRestrictions: Nestl

Foreigners holding Nestl bearer shares were

exposed to political risk in a country that is

widely viewed as a haven from such risk.

The Nestl episode illustrates

The importance of considering market imperfections.

The peril of political risk.

The benefits to the firm of internationalizing itsownership structure.

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The Financial Structure


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The Financial Structureof Subsidiaries.

In addition to taxes, political risk should be

given due consideration in the choice of a

subsidiarys financial structure.

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international capital structure and cost of capital