10 - Cost of Capital for Foreign Investment

Question 1

What is the cost of capital?

Answer 1

-Minimum rate of return that an investment project must earn to cover its funding costs (share/debtholders) and tax liabilities

Question 2

Importance of the cost of capital

Answer 2

-Used as a discount rate in calculation of PV of cash flows (value of the firm)

Question 3

Cost of ‘foreign’ capital

Answer 3

The required rate of return (to cover funding costs) for a specific foreign project (as opposed to domestic investment)

Question 4

Why is it important to examine issues related to the cost of foreign capital?

Answer 4

• Foreign investment decisions required knowledge of appropriate cost of capital of foreign subsidiaries
• Important for appraising the profitability of foreign investments
• Basic measure of financial performance

Question 5

Measuring the cost of capital - WACC

Answer 5

k(w) = k(d)(1-T)L + k(e)(1-L)

where L is the debt/assets ratio

Question 6

Cost of debt

Answer 6

• The market interest rate that the firm has to make on its borrowing. Depends on:
  1. General level of interest rates
  2. The default premium
  3. The firm’s tax rate

Question 7

Cost of equity capital

Answer 7

• Minimum required rate of return necessary to induce investors to buy or hold the firm’s stock
• Three common methods, one of which is the CAPM

Question 8

CAPM

Answer 8

• Used to estimate a firm’s cost of equity
• Assumes that firm’s need not compensate individuals for firm-specific risk because it can be diversified
• Measure of risk is the beta (measure of covariance between returns for the individual security and returns on the market)
• Beta greater than 1 = security’s return moves more than the market
• K(e) = rf + beta(K(m) - rf)

Question 9

Reducing systematic risk through diversification

Answer 9

• Much of the economic and political risk faced by the MNCs can be eliminated by diversification
• However, much of the systematic risk is related to the cyclical nature of the national economy in which the MNC is operating:
  1. Diversify across nations with different economic cycles (especially developing economies)
  2. While there is systematic risk within a nation, outside the country it may be nonsystematic and diversifiable

Question 10

NPV in an emerging market

Answer 10

• CAPM is not often used to calculate the cost of equity in an emerging market
• Must take into account the specific industry risk as well as the specific country risk (SalomanSmithBarney approach accounts for these two risk factors)

Question 11

Foreign subsidiary capital structure

Answer 11

-The capital structure of a foreign subsidiary is not independent of the capital structure of the parent company, however a highly leveraged foreign subsidiary has both advantages and disadvantages

Question 12

Advantages of a highly leverage foreign subsidiary

Answer 12

• High independence from parent firm (equity funding comes from home)
• More efficiency as management is unable to turn to the parent for help

Question 13

Disadvantages of a highly leverage foreign subsidiary

Answer 13

• Local supplier/customers may be reluctant to do business with a new subs if it is receiving minimal financial backing from parent
• The government might argue that the firm is overly leveraged and declare that certain debt payment are constructive dividends and impose taxes on those payments (destructive taxes imposed)
• Subs can’t go back to the parent in times of financial distress